Closing Auctions

The official cutoff time for submitting MarketOnClose (MOC) and LimitOnClose (LOC) orders to the NASDAQ closing auction is 3:50pm ET. For the NYSE and NYSE Amex closing auctions, the official cutoff time is 3:45pm ET. For the NYSE Arca closing auction, the official cutoff time is 3:59pm ET. With the exception of orders that are submitted to offset published imbalances, all MOC and LOC orders must be submitted before each market center’s official cutoff time.

Total Return Swaps

A TRS is a financial contract which transfers both the credit risk and market risk of an underlying asset. (It can be categorized as a type of credit derivative).

The protection seller (i.e. the investor) pays the fixed rate (i.e. LIBOR + 40 bps) to receive the return (& risk) of the underlying asset.

The protection buyer (i.e. the broker/dealer) receives the fixed rate & pays the return of the underlying asset (as well as transfers the risk of the underlying asset) to the seller.

Essentially, the protection buyer has "bought protection" by swapping the risky underlying for a fixed rate.

An advantage of a TRS is that one party (i.e. the seller) can derive the economic benefit of owning an asset without actually carrying the asset on its balance sheet while the other party, who does carry the asset on its balance sheet, is protected from loss in the asset's value.

(It is not unlike the scenario where the dealer gives the investor a loan to purchase assets, that are held with the dealer as collateral.)

Hedge funds may use TRS's to obtain leverage on the reference assets (i.e. they can post a smaller amount of collateral upfront than the size of the reference asset.)

The cost of the derivative is determined by the cost to the dealer (i.e. the buyer) of carrying the underlying position (which is made up of the financing charge for acquiring the underlying index position in the cash market, compensation for counterparty risk, dealer profit, & any adjustment for tax related expenses).

So if the cost to the investor (i.e. the seller) is "LIBOR - 40" bps to get long the return of the S&P 500...

We can view it as... The investor is borrowing money at the cost of LIBOR to buy underlying stocks. However, the actual cost is 40 bps less. This "made" 40 bps can be considered "out-performance" offered by the broker/dealer. Perhaps the broker/dealer is able to offer this out-performance due to its actual way of implementing the return (i.e. futures that roll cheap, lending stock inventory, etc.)

Alpha Transport/Portable Alpha

"Portable alpha" refers to separating the active manager’s excess return from the base market return and transporting the alpha to some other market index.

For example, to accomplish this using futures, the investor allocates a pool of capital across three strategies: The majority of the assets are invested with the active manager, a small portion is used to purchase the "other market" index futures, and index futures are sold to eliminate the market return (beta) from the active manager’s total return. The investor is then left with the active manager’s alpha plus passive exposure to the "other market" returns.

Another example for an active bond investment...

Invest in an actively managed fixed income portfolio & keep the exposure to both the fixed income beta and the manager’s alpha. Then use the fixed income portfolio as collateral for a portfolio of futures or swaps that provide equity exposure.

Note that the beta exposure, say through a third-party overlay manager buying futures or executing swaps, may require only a small portion of cash/collateral (for margin). This may allow for a greater portion of the funds to be committed to generating alpha.

Quadruple Witching

A day on which contracts for stock index futures, stock index options, stock options and single stock futures (SSF) all expire.

(Single stock futures are not at all a significant source of volume)


(Stock index futures and index future options expire on the open)
(Stock options and single stock futures expire on the close)

(Index options are cash settled.)
(ETFs and single stock options are physical)

Overnight Indexed Swap (OIS)

An Overnight Indexed Swap (OIS) (an interest-rate derivative) is a fixed/floating interest rate swap with the floating leg computed using a published overnight rate index, typically considered less risky than the corresponding interbank rate (LIBOR), in the case of the USD, the Fed Funds Effective Rate.

Two parties agree to exchange at maturity the difference between interest accrued at the fixed rate & interest accrued at the compounded floating rate on the agreed notional amount of the swap.

Net payment is made two business days after maturities

The basis convention is Annual ACT/360 (or Actual/360)

(Interest = Principal x CouponRate x Factor)

(Factor = (Actual days between the start and end dates inclusive)/360) (i.e. Assumes 360 day year)

swap receiver... receives fixed rate payments (and makes floating rate payments)

swap payer... receives floating rate payments (and makes fixed rate payments)

An OIS acts as a perfect hedge for a cash instrument...

Cash can be lent daily (i.e. in a daily accruing interest bearing account) for daily interest receipts. In contrast, the swap receiver effectively makes daily interest payments. If the daily rates 'line up,' the cash inflow can be matched with the cash outflow, the the OIS receiver has hedged the daily rate change uncertainty with a fixed rate.

OIS rates (or, in particular, the difference or 'spread' between OIS rates & LIBOR) are an important measure of risk & liquidity in the money market, considered by many to be a strong indicator for the relative stress in money markets. A higher spread is typically interpreted as an indication of decreased willingness to lend by major banks, while lower spread indicates higher liquidity in the market. The spread can be viewed as indication of banks' perception of the creditworthiness of other financial institutions & general availability of funds for lending purposes

Net Foreign Security Purchases (TIC)

Summarizes the flow of stocks, bonds, and money market funds to and from the United States (i.e. capital flow into US denomiated assets). The headline figure is the difference in value between American purchases of foreign securities and foreign purchases of American securities, expressed in millions of dollars. The Treasury International Capital or TIC statement is a major component of the American capital account and gives valuable insight into foreign demand for American investments and dollar.

A positive figure indicates that more capital is entering the US than leaving as sales of American securities to foreigners exceed American purchases of foreign securities. Positive figures suggest that American security markets are competitive with those of other countries.

Foreign security purchases are especially important in the case of a trade deficit, as a positive figure can offset the depreciating effect (on the USD) of a trade shortfall. A negative or declining TICS figure reflects a declining capital flow picture. Outflows are indicative of weaker demand for US assets which puts downward pressure on the value of the dollar.

TIC data breaks down investors into governments and private investors. Usually, a strong government holding of dollar denominated assets signals growing dollar optimism as it shows that governments are confident in the stability of the U.S. dollar. Most importantly seems to be the purchases of Asian central banks such as that of Japan and China. Waning demand by these two behemoth US Treasury holders could be bearish for the US dollar. As for absolute amount of foreign purchases, the market generally likes to see purchases be much stronger than the funding needs of that same month's trade deficit. If it is not, it signals that there is not enough dollars coming in to match dollar going out of the country. As a side note, purchases by Caribbean central banks are generally seen to be less consistent since most hedge funds are incorporated in the Caribbean. Hedge funds generally have a much shorter attention span than other investors.

Release Schedule: 9:00 AM (EST); monthly, in the second month following the reporting month

Revisions Schedule: Data are subject to revisions for 24 months following release

Source of Report: U.S. Treasury

Web Address: http://www.treasury.gov

Address of Release: http://www.treasury.gov/tic/ticsec2.html

What is Debt Monetization? How does it work?

1. Suppose the government runs a deficit... E.g. let government spending on goods and services be $10,000. For simplicity, all transactions are in cash. Let net taxes from all sources be $9,000 so there is a $1,000 deficit.

2. The government has $9,000 in cash from taxes, but needs to spend $10,000. Somehow (print money, borrow money, raise taxes, or lower spending) it must get $1,000 more.

3. Suppose it decides to borrow – issue new debt. Then the Treasury sells a government bond to someone in the private sector for $1,000. The person gives $1,000 in cash to the government and in return gets an IOU (perhaps for, say, $1,100 in one year).

4. The government now has $9,000 in cash from taxes and $1,000 it has borrowed from the public so it can now purchase $10,000 in goods and services.

5. Now let’s do the monetization step. This can happen automatically, as explained below, but for now let’s have the Fed conduct a $1,000 open market operation to increase the money supply. To do this, it cranks up the press, loads in some paper and green ink, and prints a brand new $1,000 bill. It takes the $1,000 bill and purchases a bond from the public, for simplicity make it the same bond the Treasury just issued. Then the money supply goes up by $1,000 (and may go up more through multiple deposit expansion) and government debt in the hands of the public goes down by $1,000 since the Fed now holds the bond. The increase in the money supply is inflationary.

6. What has happened? When all paper has ceased changing hands, the $10,000 in goods and services is paid for by the collection $9,000 in taxes and by printing $1,000 in new currency. The government debt simply moves from the Treasury to the Fed (in the U.S., the Fed pays for its operations from its earnings on these bonds and remits the remainder to the Treasury; I believe the remittance is weekly, but I’m not positive on that). (In other words, the Treasury just ends up owing money to the Fed.)

How can constant interest rate rules potentially cause debt monetization to occur automatically?

Suppose the Fed follows a constant interest rate rule. Further suppose an increase in government spending increases the interest rate (see here for a paper on this by Benjamin Friedman posted at the NBER site today). That is, when the government issues new debt, the supply of bonds increases lowering the price and raising the interest rate. Under these assumptions what will happen when there is deficit spending?

1. Deficit spending financed by borrowing from the private sector causes the interest rate to go up. Thus, initially two things happen, bonds held by the public (debt) increase and interest rate increases as well.

2. But the Fed is following a constant interest rate rule. Seeing the interest rate rising, what should it do? It should increase the money supply and to do so it prints money, as above, and uses it to buy bonds from the public. In order to return the interest rate to where it started, all of the debt issued in step one must be purchased with newly printed money (can you smell the fresh ink?).

3. In the end, what happens? It’s just as above, the entire deficit is financed by printing money and the debt issued by the Treasury ends up in the hands of the Fed