Abstract
This paper studies the problem of trading futures with transaction costs when the underlying spot price is mean-reverting. Specifically, we model the spot dynamics by the Ornstein–Uhlenbeck, Cox–Ingersoll–Ross, or exponential Ornstein–Uhlenbeck model. The futures term structure is derived and its connection to futures price dynamics is examined. For each futures contract, we describe the evolution of the roll yield, and compute explicitly the expected roll yield. For the futures trading problem, we incorporate the investor’s timing option to enter or exit the market, as well as a chooser option to long or short a futures upon entry. This leads us to formulate and solve the corresponding optimal double stopping problems to determine the optimal trading strategies. Numerical results are presented to illustrate the optimal entry and exit boundaries under different models. We find that the option to choose between a long or short position induces the investor to delay market entry, as compared to the case where the investor pre-commits to go either long or short.
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Notes
Statistics taken from Acworth (2015).
See p. 615 of Elton et al. (2009) for a discussion.
See Deconstructing Futures Returns: The Role of Roll Yield, Campbell White Paper Series, February 2014.
By taking a short futures position, the investor is required to sell the underlying spot at maturity at a pre-specified price. In contrast to the short sale of a stock, a short futures does not involve share borrowing or re-purchasing.
The spot price is positive, thus \(s\in \mathbb {R}_+\), under the CIR and XOU models.
For a detailed discussion on the projected SOR method, we refer to Wilmott et al. (1995).
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The authors would like to thank Sebastian Jaimungal and Peng Liu for their helpful remarks, as well as the participants of the Columbia-JAFEE Conference 2015, especially Jiro Akahori, Junichi Imai, Yuri Imamura, Hiroshi Ishijima, Keita Owari, Yuji Yamada, Ciamac Moallemi, Marcel Nutz, and Philip Protter.
Appendix
Appendix
1.1 Numerical Implementation
We apply a finite difference method to compute the optimal boundaries in Figs. 2, 3 and 4. The operators \({\mathcal {L}} \,^{(i)}\), \(i\in \{1,2,3\}\), defined in (4.2)–(4.4) correspond to the OU, CIR, and XOU models, respectively. To capture these models, we define the generic differential operator
then the variational inequalities (4.5), (4.6), (4.7), (4.8) and (4.9) admit the same form as the following variational inequality problem:
Here, g(t, s) represents the value functions \({\mathcal {V}}(t,s)\), \({\mathcal {J}}(t,s)\), \(-{\mathcal {U}}(t,s)\), \({\mathcal {K}}(t,s)\), or \({\mathcal {P}}(t,s)\). The function \(\xi (t,s)\) represents \(f(t,s;T) - c\), \(({\mathcal {V}}(t,s) - (f(t,s;T) + \hat{c}))^+\), \(-(f(t,s;T) + \hat{c})\), \((f(t,s;T) - c) - {\mathcal {U}}(t,s))^+\), or \(\max \{ {\mathcal {A}}(t,s), {\mathcal {B}}(t,s) \}\). The futures price f(t, s; T), with \(\hat{T} \le T\), is given by (2.1), (2.4), and (2.10) under the OU, CIR, and XOU models, respectively.
We now consider the discretization of the partial differential equation \( {\mathcal {L}} \,g(t,s) =0\), over an uniform grid with discretizations in time (\(\delta t = \frac{\hat{T}}{N}\)), and space (\(\delta s = \frac{S{\max }}{M}\)). We apply the Crank–Nicolson method, which involves the finite difference equation:
where
for \(i=1,2,\ldots ,M-1\) and \(j=1,2,\ldots ,N-1\). The system to be solved backward in time is
where the right-hand side is
and
This leads to a sequence of stationary complementarity problems. Hence, at each time step \(j \in \left\{ 1, 2, \ldots , N-1\right\} \), we need to solve
To solve the optimal problem, our algorithm enforces the constraint explicitly as follows
The projected SOR method is used to solve the linear system.Footnote 6 At each time j, we iteratively solve
where k is the iteration counter and \(\omega \) is the overrelaxation parameter. The iterative scheme starts from an initial point \(\mathbf {g}_j ^{(0)}\) and proceeds until a convergence criterion is met, such as \(|| \mathbf {g}_{j-1} ^{(k+1)} - \mathbf {g}_{j-1} ^{(k)} || < \epsilon ,\) where \(\epsilon \) is a tolerance parameter. The optimal boundary \(S_f(t)\) can be identified by locating the boundary that separates the regions where \(g(t,s)=\xi (t,s)\), or \(g(t,s) \ge \xi (t,s)\).
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Leung, T., Li, J., Li, X. et al. Speculative Futures Trading under Mean Reversion. Asia-Pac Financ Markets 23, 281–304 (2016). https://doi.org/10.1007/s10690-016-9215-9
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DOI: https://doi.org/10.1007/s10690-016-9215-9