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Advantages and Alternatives of Using Exchange-Traded Derivatives in Portfolio Management

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The last few years have seen explosive growth in the hedge fund industry, as consecutive years of negative equity returns have prompted

The last few years have seen explosive growth in the hedge fund industry, as consecutive years of negative equity returns have prompted investors to search for alternatives and add a new dimension to their standard asset class exposure.

Fund managers have increasingly taken advantage of futures and options products, such as Dow Jones EURO STOXX 50 derivatives. These products offer unique return opportunities to managers through holding either long or short positions to exploit market momentum, specific macroeconomic movements or arbitrage opportunities.

Exchange-Traded Derivatives

Trading volumes in exchange-traded futures and options markets have also increased dramatically over the last couple of years. This growth in demand for derivatives products mirrors investors’ appreciation of the benefits of these products, in particular lower transaction and market impact costs, use of leverage and liquidity. In addition, compared to trading derivatives over-the-counter (‘OTC’), an organized exchange with an intergrated clearing house provides investors with a higher level of transparency and reduced counterparty risk.

A particularly significant area of growth has been the use of equity index futures. Rather than requiring investors to hold all constituent securities in an underlying benchmark, equity index futures trade as a single instrument representing the return of a security basket. The number of Dow Jones EURO STOXX 50 Futures contracts traded in the third quarter of 2003 was 47% higher compared to the same quarter last year. The corresponding figure for the Dow Jones EURO STOXX 50 Options was 79%. Open interest grew by 11% and 51% respectively for the futures and options over the same time period.

Exchange Traded Funds

Alternatives to using futures are program trades in underlying shares or exchange traded funds (‘ETFs’). Similar trading strategies can often be initiated through either the underlying shares, ETFs or derivatives. However, the products have several differences which make one or the other more suitable depending on the investor’s current situation. For managers who need to change their positions frequently as a situation unfolds, trading costs are a significant factor in deciding which trading instrument to use. Holding costs play a relatively larger role for managers with longer horizons. Futures are listed with three-month expiration cycles, which leads to roll costs in the form of bid/ask spread, i.e. closing the old positions at the end of the cycle and opening new ones. This is not the case with the underlying shares or ETFs, although a management fee is charged for ETFs.

Turnover and Liquidity

The table below shows the average daily turnover in the underlying shares, ETFs and Dow Jones EURO STOXX 50 Futures. It should be taken into account that, unlike a futures contract where the trading volume and open interest on the exchange are factors considered by potential users, the liquidity of an ETF is not determined exclusively by its trading volume on the exchange but rather by the liquidity of the constituents of the index being replicated. Therefore, when faced with a large order in what seems like an illiquid ETF, Market Makers can create new ETF shares and their ability to do so at the prevailing price is determined by the liquidity available in the underlying constituents of the index.

Table: Daily Average Volume, Market Capitalization and Open Interest, September 2003

  Volume in EUR (millions) Market capitalization in EUR (millions, as of Sept. 30)
DJ EURO STOXX 50SM 193,014.77 1,187,824
ETFs traded on Xetra    
  Xetra order book turnover in EUR (millions) Assets under management in EUR (millions, as of Sept. 30)
DJ EURO STOXX 50SM EX 1,045.99 1,276.94
iShares DJ EURO STOXX 50SM 279.32 1,163.86
Fresco DJ EURO STOXX 50SM 64.52 145.68
DJ EURO STOXX 50SM Master Unit 7.93 1,212.30
Futures traded on Eurex    
  Volume in EUR (millions) Open interest in EUR
(millions, as of Sept. 30)
DJ EURO STOXX 50SM 344,667 33,935
  Traded contracts Open interest in contracts
(as of Sept. 30)
DJ EURO STOXX 50SM 13,500,846 1,411,021

Source: Deutsche Börse AG, STOXX Ltd.

Derivatives and ETFs provide cost-efficient risk management tools and they can be used as complementary trading instruments. Arbitrage opportunities between the cash, ETF and derivatives markets lead to narrow spreads. This, in turn, ensures price equilibrium across markets and increases the price quality and transparency for the market overall.

Click here for more information regarding equity index derivatives 

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