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Sunday, September 27, 2020

Short FKLI Spread Oct / Dec

Short FKLI Spread Oct / Dec
Author: i3gambler | Publish date: Sun, 27 Sep 2020, 12:53 PM

http://psasir.upm.edu.my/id/eprint/3297/1/Price_Efficiency_of_Stock_Index_Futures_Contracts.pdf?fbclid=IwAR33AZMGYPcBSmLZMjAt-Nia6YJqQVcqjbaqCRIPBRqHDFoQUlyFgpzhLSY

Please read and understand from the above document on how to calculate fair value of FKLI.

The formula is simple:

PFAIR = PC (1 + i)^t - D

As the longest life of FKLI is only 8 months,

The above formula can be simplified to:

PFAIR = PC (1 + i*t) - D

where

PFAIR = the fair futures price for a stock index

PC = the current value of the underlying cash stock index

i = the financing rate of interest or equivalent investment return desired

D = the dividend amount in index points to be received on the stocks in the index from now until the expiration of the futures contract

t = number of days until expiration of the futures divided by 365



Make reference to the above screen shot:

Now I show you an example how to calculate the fair value of FKLI for Dec 2020.

PC = 1509.14

i = 2.50%

D = 3.2+2.3+3.9 = 9.4

t = 95 / 365

Therefore

PFAIR = 1509.14*(1+ 0.025* 95 / 365) - 9.4 = 1509.5 (round to nearest 0.5)

After we get the fair value for all the FKLI, then the fair value for FKLI Spread can be calculated:

For an example:

For i = 2.50%,

FKLI Oct fair value = 1507.0

FKLI Dec fair value = 1509.5

Therefore, FKLI Spred Oct / Dec = 1507.0 - 1509.5 = -2.5

The calculation is simple, the critical part is what interest rate to be used?

We can only guess:

1) Mr A has plenty of cash, he is thinking either to buy stocks with his cash or long a FKLI and put his cash in bank FD. He will go and find out his FKLI breakeven point.

2) Mr B does not have much cash, he is thinking either to buy stocks by margin facility or just long a FKLI instead. He will also go and find out his FKLI breakeven point.

3) Mr C has a lot of stocks in hand, he is thinking either to sell off all his stocks or just short a FKLI. He will also go and find out his FKLI breakeven.

So, the fair value for FKLI will be the average of the above breakeven points.

However, there are also a lot of speculators who do not know how to calculate the fair value, they just simply bet like gambling. Then the market price will be away from the fair value.

Now focus on FKLI Spread Oct / Dec,

As the FD rate should be around 1.75% now, and I think the margin account interest rate should be around 3.25%,

I would guess the fair value for FKLI Spread Oct / Dec should be somewhere between -4.5 to -0.5 point.

But the market price is 9.5 points, wow, very far away from its fair value!

Then what should I do?

Short lah, short FKLI Spread Oct / Dec!

However, we must understand that FKLI Oct will be settled at end of Oct, meaning by then we must do one of the following:

1) Long FKLI Oct, or just let it cash settled automatically, then your position is no longer a spread and become purely a "Long FKLI Dec", you need much more deposit for it, and of course higher risk / opportunity after that.

2) Long FKLI Spread Oct / Dec to close the position.

3) Long FKLI Spread Oct / Nov, so that your position become "Short FKLI Spread Nov / Dec".

4) Long FKLI Spread Oct / Mar, so that your position become "Long FKLI Spread Dec / Mar".

Last One, very important, I must say three times:

Trade at your own risk!

Trade at your own risk!

Trade at your own risk!

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