Spread Plays

The china vs taiwan spread trade has done well in the short term with 7% gains over the last two days, but not for the reasons I discussed in the previous post. I noticed that the markets are cointegrated, however moves in the china market (both positive and negative) have a steeper slope, so that positive and negative moves are bigger with FXI than for EWT.

Given the current downward trend for FXI, the FXI - EWT spread contracted, yielding 7%. Of course should the trend reverse and FXI recover, would expect the spread to flip back to a widening phase.

I think a better trade at this point is a view towards continued growth in the indian market accompanied with a deflation of the chinese market bubble. Speculative trade: short FXI, long INP.

Spread play: China vs HK market?

If one looks at the annual performance of FXI (China index) versus EWH (HK index), we see a widening spread over the last year, but a lot of simularity in the chart patterns. I suspect these markets are cointegrated, but with a scaling factor (a difference in slope).

This article indicates that chinese will soon be able to invest in the HK market. With the huge flow of speculative money in China soon to be able to find alternative venues (such as HK), should expect to see a move of some of this buying pressure into the HK market.

A speculative play: looking to see a contracting FXI - EWH spread. Trade: buy EHW, sell FXI.

A Bad Deal?

I was looking at investments offered in my offshore account and came across the following structure:

• 5 year investment into china fund
• capital preservation (built-in floor at initial investment level)
  
• max 55% return total across 5 years, the bank pockets the excess above
  

For someone not in the financial business this may seem to be a good deal (seeing the 55% and capital preservation). I think it is a relatively poor deal though. The continuously compounded effective annual rate is only ~8% and that is only achieved if the market does indeed appreciate 55%.

I began thinking about how closely could replicate this structure on my own, but with a much higher max payoff. Though the payoff function I am going to indicate is not perfect (I can go under my initial capital if the timing of my protection is not right), would do as follows:

Initially

• buy into FXI index
• allow some appreciation and then buy the 1 month put option at the initial point of entry

On an ongoing basis:

• roll put option at initial investment point + cost of option premiums thus far, maybe with longer maturity
• if FXI drops below initial investment, sell FXI, sell option, coverage should be close to offsetting
• as and if FXI approaches entry point buy in again and buy protection
• repeat
  

Of course one can structure this more advantageously:

• additional protection (by adjusting strike upwards as FXI gains)
• reentering trade if FXI falls at lower level rather than initial investment level
  

The cost of the options is paid for out of the returns or in the worst case through the adjusted strike price. That said, increasingly, the options are going to be deeper and deeper out of the money if FXI continues to be a good investment (meaning cheaper hedging costs).