DIEFUSODBA
S&P 500DJ-30Nasdaq-100Russell 2000Nikkei 225DAXCAC 40EURO STOXX 50EuroGOLD7–10 Year Treasury BondCRUDE OILAgricultural Commodities
500600100060030001500150050080090020006001500
50060010005002500150013004007004002000600800
200 000 00017 000 000170 000 000100 000 00024 000 0002 200 000500 000640 000200 00010 000 000360 00013 000 0001 500 000
The constant, currently equal to 50.14348112, was set back at the initiation of theindex in order to make the index equal to 100.00 at that time.An example of calculating the dollar index on 8 February 2008 using formula (4.1)is depicted in Table 4.7. The FX rates (from Bloomberg) are raised to the negative oftheir weight, and the product, when multiplied by the index constant of 50.14348112,yields the dollar index level of 76.67 on that date.The index was calibrated to par or 100 in March 1973 when the world’s majortrading nations abandoned the 25-year-old Bretton Woods agreement to fix theircurrency rates. Thus a quote of 84 means the dollar’s value has declined 16 % sincethe base period.The dollar index component currencies and their weightings are: Euro (57.6 %);yen (13.6 %); British pound (11.9 %); Canadian dollar (9.1 %), Swedish krona(4.2 %); and Swiss franc (3.6 %). These are depicted in the pie chart in Fig. 4.1 and inTable 4.7.Intraday values for the dollar index are generally not available from data providers.However, a rough indication of the dollar index intraday change can be estimated bythe EUR/USD FX rate because, as you can see from Table 4.8, three of the dollarindex components – the British pound, the Swedish krona and the Swiss franc – arehighly correlated with the euro.
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Intermarket Trading Strategies
There’s no doubt that the dollar index plays a dominant role in the financial marketsand the dollar’s daily changes have major effects on many other asset classes likecommodities, precious metals, the bond and stock markets.From the end of World War II until the early 1970s, the dollar was tied to other majorcurrencies by the Bretton Woods fixed exchange rate agreement. After it became freefloating, the dollar went through a roller-coaster ride. It rose to an all-time high of160 in 1985 but then retreated to almost where it started. At the beginning of 2002 itrose again to 120, making a 16-year high and more recently, in 2008, mainly becauseof the huge US trade deficit, it plummeted to an all-time low of 70.The main fundamental factors affecting the dollar index are:• the US trade deficit;• US, Japanese, Canadian and European interest rates and bond yields;• CPI inflation;• quarterly gross national product (GDP);• non farm payroll figures.A quantitative statistical analysis of the relationship between the dollar index andthe factors mentioned above would reveal the magnitude of their correlation with thedollar index and to what extent they might have an influence on the dollar’s futurevalue.While data on tradeable instruments such as bond yields, the dollar, internationalbonds etc. are readily available, it is sometimes difficult to find appropriate fundamental data because they are often subject to revision and not always reported in adata-compatible format.Table 4.9 lists some markets with readily-available data that correlate well withthe dollar index and covers the 5-year period from January 2003 to December 2007(in the second column) and the 10 years from January 1998 to December 2007(in the third column). I included both a short and a long time span because, as itbecomes apparent from Table 4.9, the correlations were not constant over time, usuallystrengthening during the most recent 5-year period. This was more pronounced inthe case of the CRB index, crude oil and gold, mainly because investors turned tocommodities as a hedge against the recent disorderly dollar decline.The British pound, the euro and the yen had the highest negative correlation inboth time spans, but this was expected as they are all components of the dollar index.The commodity that correlated best with the dollar index was gold (r = −0.51). Ofcourse this is nothing new and it is normal for gold, which is denominated in dollars,to have a negative correlation with the dollar. Surprisingly, the dollar index correlatedbetter with the Australian dollar, which is not a dollar index component, than withGold.Lastly, the dollar index did not correlate well with equity indices. The correlationwith the S&P 500 reversed sign from weak positive to weak negative during thelatest 5-year period. The equity index that correlated best with the dollar index was
International Indices and Commodities
53
Table 4.7 Shows the FX rates of the dollar index constituent currencies on 8 February 2008(from Bloomberg). The weights applied to the FX rates are shown in the third column, andthe FX rate raised to (the negative of) that weight in the last column. This product, whenmultiplied by the constant of 50.14348112, yields the dollar index of 76.67 on 8 February2008. All FX rates are expressed in USD per unit of the foreign currency.Currency
FX rate
Weight
(FX rate) −Weight
EuroYenSterlingCanadian dollarSwedish kronerSwiss francConstant
1.45070.00931.94601.00080.15400.9065
0.5760.1360.1190.0910.0420.036
0.80710733841.88923646280.92382987520.99992723181.08174309011.003540164650.14348112
Product (index level)
76.67EUR 57.6 %JPY 13.6 %GBP 11.9 %CAD 9.1 %SEK 4.2 %CHF 3.6 %
SEK 4.2 %CAD 9.1 %
GBP 11.9 %EUR 57.6 %
JPY 13.6 %
Figure 4.1 The dollar index.Table 4.8 2- and 5-year nonparametric correlation between the euro and the rest of thedollar index component currencies. Notice the high correlation between the euro and theBritish pound, Swedish krona and Swiss franc. All rates are expressed in USD per currency.Correlations with the euroYears
JPY
GBP
CAD
SEK
CHF
25
0.039−0.077
0.9740.957
0.6590.638
0.9850.983
0.9150.953
International Indices and Commodities
55
Table 4.9 Correlation of monthly (21 day) percentage yields betweenthe dollar index and related commodities. In the second column is thecorrelation using more recent data from 1 January 2003 to 31 December2007 and the correlation using 10 years of data (from 1 January 1998 to31 December 2007) in the third column.Correlation Data – YearsIndex/CommodityOIXCrude oil (NYMEX)Natural gasS&P 500NikkeiVenture (Canada)XAUSilverGold (cash)CRB indexUtility IndexJapanese BondsBundBonds10-yr Australian bond10-yr Treasury yieldInterest rates (short)EuroAUDGBPYEN
5
10
−0.23−0.26−0.14−0.170.12−0.36−0.36−0.33−0.51−0.39−0.29−0.10−0.15−0.16−0.100.160.14−0.98−0.66−0.84−0.65
−0.13−0.13−0.160.010.13−0.31−0.35−0.29−0.49−0.32−0.11−0.10−0.20−0.23−0.250.260.18−0.98−0.56−0.80−0.56
Canada’s Venture Index. This was no surprise as the Venture Exchange is heavilyweighted with gold mining stocks.Dollar index futures trade in the NYBOT (which has been recently acquired by theIntercontinental Exchange or ICE) under the symbol DX. The contract value is 1000times the index and is currently trading at 73. Thus, if you sell one contract, you arebasically shorting $73 000 against a basket of six foreign currencies.
4.9
THE XOI AND THE OIX
The continued surge in the price of oil confirms that oil supply is scarcely meetingdemand. The excess demand is coming from China and India and will only getstronger. The question is not whether, but when, world crude productivity will start
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Intermarket Trading Strategies
to decline, ushering in the permanent oil shock era. While global information forpredicting this “event” is not so straightforward as the data M. King Hubbert usedin creating his famous curve that predicted the US oil production peak, there areindications that most of the large exploration targets have been found, at the sametime that the world’s population is exploding.On 26 February 2008 crude oil prices crossed the $100 barrier. High crude pricesimply higher profitability for the oil industry which, in turn, will propel their stockprices even higher.The AMEX oil index (XOI) and the CBOE oil index (OIX) are the most popularindices designed to measure the performance of the oil industry through changes inthe prices of a cross section of widely-held corporations involved in the exploration,production, and development of petroleum.The XOI was established with a benchmark value of 125 on 27 August 1984and currently has 12 component companies, all involved in exploring, developing,producing, and refining petroleum. These range in size from the tiny $29 billion(market capitalization) Hess to the mighty $440 billion Exxon Mobil, the world’slargest publicly-traded oil company.Both indices are price weighted. Perhaps surprisingly, considering its use withthe DJIA, price-weighted indices have major problems. In the XOI’s case, thesmaller and less-important companies now have far higher share prices than thebig ones. This allows these smaller companies to unduly influence and distort indexperformance.For example Apache, because of its rich $100 share price, comprises 11.7 % ofthe OIX by weight even though it is only a $33 billion company. Meanwhile, giantExxon Mobil is weighted at 10 % of the XOI even though it is a massive $440 billionbehemoth. The problem is that share prices are meaningless, and a company of anysize can have whatever share price range it wants by splitting or reverse-splitting itsstock.An alternative and better way to weight an index, which is more common in newerindexes, is by market capitalization. This weighting solves the problem of a $1 movein a $10 stock having the same impact as an identical move in a $100 stock, despitethe fact that the former situation represents a 10 % change, and the latter only a 1 %change. Not surprisingly, market cap weighted indexes are by far the most common.The classic example always provided for the market-weighted index style is theStandard & Poor’s 500 index.With the XOI’s current price weighting, the bottom four components – whichrepresent a hefty 23 % of the XOI’s weight today – are a mere 9 % of its marketcapitalization!Despite these problems, the XOI remains the most popular measure of the oil-stocksector today with the OIX a close second.For comparison purposes, both the XOI and OIX components are listed in thesame Table 4.10. As you can see their composition and weight are very similar. The
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Table 4.10 Composition of the CBOE oil index (OIX) and Amex oil index (XOI) as of 2February 2008. A blank cell indicates that the stock in that row is not included in the index.
Symbol
Name
Price8/2/08
Marketcap – billion
OIXweight
XOIweight
APAHESXOMCVXTOTRDS.ACOPOXYBPAPCMROREPVLO
Apache CorpHess CorpExxon Mobil CorpChevron CorpTotalRoyal Dutch ShellConocophillipsOccidental PetroleumBritish PetroleumAnadarko PetroleumMarathon Oil CorpRepsol Ypf S.AValero Energy
100.6356.4664.3075.3879.2688.9649.3866.6867.5370.2981.7131.8859.06
33.528.6439.8165.5158.3124.0119.955.1202.826.435.037.132.1
11.74 %10.41 %10.38 %10.24 %9.64 %9.28 %9.09 %8.49 %8.02 %6.84 %5.87 %––
–10.36 %9.86 %9.64 %8.30 %8.15 %9.16 %7.74 %7.27 %6.68 %5.34 %3.64 %6.75 %
main difference between them is that the Amex used Apache Corporation instead ofCBOE’s Repsol and Valero.Table 4.11 lists some markets that correlate well with the Amex oil index. Thedata are composed of equity indices, commodities, currencies and interest raterelated markets. I statistically correlated these against the XOI on a same monthbasis, meaning there was no monthly offset between the XOI data series and therelated markets. The highest correlation in both time spans was between the XOI andCanada’s TSX index, but this was to be expected as the TSX is heavily weighted withoil exploration stocks. Surprisingly, Japanese bonds correlated considerably betterwith the XOI (r = −0.31) than US Treasury bonds (r = −0.1). Interest rates hadvirtually no correlation with the XOI.As can be seen in Table 4.11 the correlations were not constant over time, sometimes strengthening from weak to medium or strong during the most recent 5-yearperiod. This was more pronounced in the case of the dollar and dollar denominatedcommodities such as gold, crude oil, and the CRB index.The XOI correlated better with the Australian dollar than the US dollar index andthere was also strong positive correlation with the Australian All Ordinaries index.This was certainly a surprise since Australia is not a major oil-producing country.Options on the OIX trade on the CBOE under the symbol OIX expiring every threemonths from the March quarterly cycle (March, June, September and December).Options on the XOI are also available from the AMEX.
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Intermarket Trading Strategies
Table 4.11 Correlation of monthly (21 day) percentage yields between the Amexoil index (XOI) and related indices. The correlation using more recent data from1/1/2003 to 31/12/2007 is shown in the second column and the correlation using10-year data (from 1/1/1998 to 31/12/2007) in the third column.Correlation Data–YearsIndex/commodityOIXCrude oilBrentNatural gasS&P 500TSX (Canada)Venture (Canada)Australia All OrdinariesXAUGoldCRB indexJapanese bondsUtility index10 yr Treasury bond10 yr Treasury yieldDollar indexAUDGBPYen
4.10
5
10
0.990.520.490.30.480.740.490.540.540.370.57−0.310.45−0.120.04−0.210.380.05−0.06
0.990.420.430.310.460.470.470.430.400.160.44−0.310.44−0.10.1−0.120.330.080.05
THE CRB INDEX
The history of the CRB index dates back to 1957, when the Commodity ResearchBureau constructed an index comprised of 28 commodities to track the performanceof commodities as an asset class.Since then, as commodity markets have evolved, the index has undergone periodicupdates. Its name was changed to the Reuters CRB Index in 2001 and it was againrenamed as the Reuters/Jefferies CRB Index (RJ/CRB) in July 2005 when it underwent its tenth and most recent revision, the collaborative effort of Reuters Plc. andJefferies Financial Products, LLC.The original CRB index included 28 commodities until the list was reduced to21 in 1987, where it remained until a major revision in 1995 when it was furthersliced down to 17 commodities. Of the 28 commodities included in the original CRBof 1957, foodstuffs such as rye, potatoes, onions and lard – that aren’t really relevantto an evolving industrial economy – were gradually removed.
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Table 4.12 Commodities included in the old and new CRB index andthe Goldman Sachs Commodity Index (as of April 2007).
Crude oilBrentHeating oilUnleaded gasNatural gasGas/OilCornWheatSoybeansSugarCottonCoffeeCocoaOrange juiceCattleLean hogsGoldSilverAluminumCopperNickelPlatinumLeadZinc
Old CRB
New R/J CRB
GSCI
5.9 %0.0 %6.0 %0.0 %5.9 %0.0 %5.9 %5.9 %5.9 %5.9 %5.9 %5.9 %5.9 %5.9 %5.9 %5.9 %5.9 %5.9 %0.0 %5.9 %0.0 %5.9 %0.0 %0.0 %
23.0 %0.0 %5.0 %5.0 %6.0 %0.0 %6.0 %1.0 %6.0 %5.0 %5.0 %5.0 %5.0 %1.0 %6.0 %1.0 %6.0 %1.0 %6.0 %6.0 %1.0 %0.0 %0.0 %0.0 %
37.9 %15.5 %6.2 %1.3 %6.2 %5.4 %3.0 %5.9 %2.1 %0.9 %0.8 %0.6 %0.2 %0.0 %2.8 %1.1 %2.0 %0.3 %2.4 %3.0 %0.9 %0.0 %0.5 %0.7 %
During the latest revision in 2005 three new commodities were added (unleadedgas, aluminum and nickel) and an existing one (platinum) was eliminated for a netgain of two components. In addition, the CRB’s traditional geometric averaging wasalso eliminated, in favor of a weighting arithmetic averaging which better tracksthe true direction of commodities prices during today’s volatile markets. By itsvery mathematical nature geometric averaging effectively continually rebalancedthe index, decreasing exposure to rising commodities and increasing exposure todeclining commodities.To refresh the readers’ mathematics, the formula for the geometric mean of a dataset [a1 , a2 , . . ., an ] is the nth root of their product and it is useful for averagingquantities with the same or similar values in magnitude.In the new CRB, crude oil has a weight of 23 times the weight of orange juiceor hogs and 4.6 times the weight of sugar. You can see the composition of subsector weightings of the new RJ/CRB in Fig. 4.2 and the individual commodities inTable 4.12.
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Intermarket Trading Strategies
By diversifying into commodities, investors are better able to obtain desirablelong-term results, while at the same time lowering the overall volatility of theirportfolio.The counter-cyclic nature of commodities to other financial assets such as equitiesmakes commodities an ideal asset class to incorporate into a portfolio in order toachieve a more desirable return scenario. Attempting to find the right combination ofcontracts in obscure markets such as soybeans, pork bellies, cattle, and coffee wouldbe difficult for a futures market professional and potentially disastrous for anyoneelse. Many mutual type commodity funds and money managers have surfaced, butmost with unpredictable results and very few offering the true commodity portfolionecessary for proper asset diversification.The Reuters/Jefferies CRB index has been recognized as the main barometer ofcommodity prices for many years and has been accepted globally as a standard formeasuring the commodity futures price level.To alleviate the need to choose individual commodities while facilitating the investment in a representative group, the New York Board of Trade (NYBOT) beganoffering futures contracts on the Reuters/Jefferies CRB index. The trading symbol isCR and the contract size is 200 times the index.Buyers of the Reuters/Jefferies CRB index futures contract have direct participationin valuation changes of the component commodities (see Table 4.12 and also Figure4.2). A “long” position provides opportunities for obtaining a hedge against inflationand dollar depreciation while at the same time reaping potentially extraordinaryreturns from commodity price appreciation.
4.11
THE GOLDMAN SACHS COMMODITY INDEX (GSCI)
The GSCI, created in 1991, currently includes 24 commodities and is designed toprovide investors with a reliable and publicly available benchmark for investmentperformance in the commodity markets. Individual components qualify for inclusionin the GSCI on the basis of liquidity and are weighted by their respective worldproduction quantities in the last five years of available data. A list of the componentsand their dollar weights, as of April 2007, is presented in Table 4.12.The GSCI is heavily weighted in energy futures contracts, which constitute 72.5 %of the index compared with only 39 % for the Reuters/Jefferies CRB index, which wasthe main factor for the GSCI becoming the top-performing commodity benchmark in2007. This, however, is not necessarily an advantage, as it limits the diversificationinto other commodities which is especially beneficial in periods of declining oilprices.In Fig. 4.3 you can see a comparison between the Goldman Sachs commodityindex (thick line), the RJ/CRB index (normal line) and crude oil futures (thin line).Notice how the Goldman Sachs commodity index closely follows crude oil prices.
International Indices and Commodities
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Figure 4.2 Sub-sector composition of the new RJ/CRB index. The Energy group includescrude oil, heating oil, unleaded gas and natural gas; the Grain group includes corn, wheat andsoybeans; the Meat group includes live cattle and lean hogs; the Tropicals include sugar, cotton,coffee, cocoa and orange juice and lastly, the Metals group includes gold, silver, aluminium,copper and nickel.
Possible means of investing in the Goldman Sachs commodity index include thepurchase of GSCI-related instruments, such as the GSCI futures contract traded onthe Chicago Mercantile Exchange (CME).In February 2007 the GSCI was acquired by Standard & Poor’s and renamed theS&P GSCI.
4.12
THE XAU AND THE HUI
The Philadelphia Exchange (PHLX) Gold and Silver Sector (XAU) Index is acapitalization-weighted index composed of 16 companies involved in the gold andsilver mining industry. The XAU was set to an initial value of 100 in January 1979.Options on the XAU trade under the same symbol in the Philadelphia Exchange.The component companies and their weighing can be seen in Table 4.13.
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Intermarket Trading Strategies
Figure 4.3 Weekly chart of the S&P Goldman Sachs commodity index (thick bold line withthe scale on the right), the RJ/CRB index (thin black line) and crude oil futures (thin greyline) from 2001 to February 2008. Notice how the Goldman Sachs commodity index closelyfollows crude oil prices.Table 4.13 Composition of XAU index as of 8 February 2008.Company name
Symbol
Weight
Barrick Gold Corp.Agnico Eagle Mines Ltd.AngloGold Ashanti Ltd.Yamana Gold, Inc.Coeur d’Alene Mines Corp.Freeport McMoran CopperGold Fields Ltd.Goldcorp, Inc.Randgold Resources Ltd.Harmony Gold Mining Co.Kinross GoldNewmont Mining CorporationPan American Silver Corp.Royal Gold, Inc.Silver Wheaton, Inc.Silver Standard Resources
ABXAEMAUAUYCDEFCXGFIGGGOLDHMYKGCNEMPAASRGLDSLWSSRI
22.04 %4.39 %5.64 %5.15 %0.62 %17.54 %4.63 %13.00 %1.74 %2.10 %6.64 %11.97 %1.34 %0.44 %1.70 %1.05 %
International Indices and Commodities
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Table 4.14 Composition of HUI index as of 1/31/08.Company name
Symbol
Weight
Barrick GoldNewmont MiningGoldcorp Inc.Yamana GoldRandgold Resources AdsAgnico Eagle MinesKinross GoldGolden Star ResourcesEldorado Gold CorpGold Fields Ltd. AdrHarmony Gold MiningCoeur d’Alene MinesHecla MiningIamgoldcorpNorthgate Minerals
ABXNEMGGAUYGOLDAEMKGCGSSEGOGFIHMYCDEHLIAGNXG
17.16 %14.53 %10.04 %5.83 %5.81 %5.42 %5.40 %4.95 %4.89 %4.61 %4.38 %4.38 %4.32 %4.22 %4.06 %
Another popular gold mining index is the AMEX’s Gold BUGS index (HUI).BUGS is an acronym for Basket of Unhedged Gold Stocks. The index was introducedon 15 March 1996 with a starting value of 200.The AMEX Gold BUGS index is comprised of 15 of the nation’s largest “unhedged” gold mining stocks. It is a “modified equal-dollar weighted” index. As aresult, most of the index’s component stocks are equally weighted, yet the largeststocks still carry a greater weight than the smallest. The component companies andtheir weighing on the 31 January 2008 are depicted in Table 4.14.The major difference between the two indices is that BUGS is made up exclusivelyof mining stocks that do not hedge their gold positions more than 18 months into thefuture. This makes the BUGS index much more profitable than the XAU when goldprices are rising, but can also compound its losses when gold declines.
4.13
THE VIX
The CBOE Volatility Index (VIX) is designed to reflect investors’ consensus viewof future (30-day) expected market volatility by averaging the weighted prices ofout-of-the money options on the S&P 500 (SPX) index.The name might be misleading as the VIX is not really a measure of marketvolatility but only of the price level of the SPX options, which is somewhat subjectiveand varies by opinions about the options that have nothing to do with volatility. TheVIX also tells us something very important about the price of the options from which
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Intermarket Trading Strategies
it is derived: It indicates whether the options are expensive or cheap relative to theirhistorical prices. When the VIX is high, options are expensive, and when it is low,options are cheap. The option premium usually goes up when the market declinesand it is usually a sign of fear.I consider the VIX as a sentiment indicator because, unlike surveys and collectionsof information about bullishness or bearishness, it is an indicator based on tradersusing their capital during the course of the trading day willing to pay more for SPXput options if they perceive that a market correction is imminent. In that sense theVIX is the collective wisdom of the market at that instant.There are three variations of volatility indexes: the VIX which tracks the S&P 500,the VXN which tracks the Nasdaq 100 and the VXD which tracks the Dow JonesIndustrial Average.The original VIX, introduced by the CBOE in 1993, measured the implied volatility or the amount that the OEX (S&P 100) options were selling above or below theirfair value (as calculated by the Black-Scholes formula). The use of the Black-Scholesformula (which embodied a number of other factors like interest rates, time to expiration and historical volatility) tended to sometimes distort the expected volatilityand so, in September 2003 the CBOE decided to change the calculation method. Thenew VIX used a newly-developed formula to derive expected volatility by averagingthe weighted prices of the 30-day to expiration, out-of-the money puts and calls andwas independent of the Black-Scholes option pricing model. The second noteworthychange was that the new VIX calculation