The launch of Amex DIAMONDS creates arbitrage opportunities for institutional investors, because they provide a natural complement to CBOT DJIA futuresswith each DIAMONDS share representing 1% of the DJIA stock basket.
Arbitrage Between CBOT DJIA futures and DIAMONDS
The theoretical price relationship between the CBOT.DJIA futures and DIAMONDS is no different than the price relationship between the cash DJIA and the CBOT DJIA futures. That means the fair value for March '98 futures equals 1,000 times the DIAMONDS price plus financing costs and less cash dividend distributionssbecause DIAMONDS, which trade just like stock, pay out dividends. (The Amex schedule of ex dividend and payment dates for DIAMONDS shares differs slightly from the schedule for an outright portfolio of DJIA stocks.) Whenever the CBOT DJIA futures price is out of line with its fair valuesbased on the DIAMONDS pricesan arbitrage opportunity exists. Simply buy the cheaper instruments and sell the one that's overpriced to capture the inefficiency. Unwind the position in one of two ways:

* Hold the spread until futures expiration, when the prices of each converge.
* Wait until the fair value and futures price come back into line and then liquidate.

On January 20, 1998 the price of a DIAMONDS share was $78 2/64, or $78.03, and the price of March '98 futures was 7810. The LIBOR three-month rate was 5.625%. The value of DIAMONDS dividends accruing until expiration is approximately $0.31 per share. The fair value of March '98 CBOT. DJIA futures was 7845.
Fair Value = 7803 (1 + .05625 x 60/360) - 31 = 7845
You can see that the futures is underpriced relative to its fair value by 35 index points, making it profitable to buy futures and short 1,000 DIAMONDS per futures contract.


CASE 1: UNWINDING AT EXPIRATION

At expiration, the price of March '98 CBOT. DJIA futures settles to the special opening quotation (SOQ) of the DJIA, and DIAMONDS shares sold short on January 20 can be bought at the opening of trade at a price closely related to the SOQ. For this example, assume these two prices are the same: DIAMONDS are bought at SOQ/100 per share. The return per futures contract is $350.

$10(SOQ - 7810) + 1,000(78.45 - SOQ/100) = $350


CASE 2: EARLY LIQUIDATION

Stock index arbitrages are often unwound as soon as the mispricing is reversed, possibly the same day. Suppose that later in the day on January 20, the price of DIAMONDS decreases to $77 20/64, or $77.31, and the price of March '98 futures decreases to 7795. Liquidating the arbitrage spread at this point yields a greater dollar return over a shorter period of time than holding it until expiration. The return per futures contract is $570.

$10(7795 - 7810) + 1,000($78.03 - $77.31) = $570
There may be some price slippage because the orders on the cash and futures side of an arbitrage position can't always be executed simultaneously. But DIAMONDS have characteristics that allow their arbitrage against CBOT. DJIA futures to be rather seamless.


1) With DIAMONDS, you don't need to trade individual DJIA stocks to build a cash basket equivalent to one CBOT. DJIA futures contract. Given the different valuations, you need 1,000 DIAMONDS shares for every futures contract. The standard trading unit for DIAMONDS is 100 shares, or one round lot.
2) DIAMONDS are eligible cash market counterparts to a CBOT. DJIA Exchange for Physical (EFP) transaction. EFPs are futures transactions that can be executed outside the pit, as long as they are associated with a cash market component that is well correlated to the CBOT. DJIA futures price.
The CBOT. DJIA EFP facility enables brokers to bundle the DIAMONDS and futures legs of a DJIA spread in a single transaction where the cash and futures price are determined simultaneously. This eliminates execution risk and decreases price slippage. An additional advantage is that EFPs extend trading past regular floor trading hours.
3) DIAMONDS are exempt from the short sale rule, and so can be sold short on a downtick. The exemption of DIAMONDS from the short sale rule removes an important source of execution risk for spreads of cash and futures positions.
4) DIAMONDS index arbitrage orders are not hampered by trading "collars," such as the NYSE's side-car rule or Rule 80A.

5) There is no fee for orders of up to 5,099 DIAMONDS share routed through PER, Amex's automated order routing system.


For more information, please contact Catherine Shalen, Senior Economist, Market & Product Development, at 312-341-3267