Prepared by Berkeley Futures, Ltd.

A martian with a basic knowledge of economics landing in Germany last week would have been totally baffled as to why the Bundesbank had decided to raise short-term interest rates from 3 to 33 percent. The decision was made just three days after September's jobs data showed that unemployment had risen to a new post-war high of 4.5m. The move sparked off coordinated interest rate rises in Belgium, Denmark, France and the Netherlands.

The Bundesbank justified the move on grounds of domestic inflationary pressures. The economy is beginning to pick up only after years of sluggish underperformance. The sharp depreciation of the Deutschemark against the dollar over the past two years will eventually give an upward twist to prices but, with the inflation rate running at 1.9 percent per annum, it is not yet apparent. The real reason for the move was that it was the opening gambit in the endgame of Emu. (The Bundesbank could not admit that its actions were influenced by European considerations because, under the terms of its constitution, it is only supposed to adjust monetary policy in response to domestic factors.)

Prior to monetary docking, economies need to converge in order to ensure a smooth transition to the Euro. Earlier attempts to achieve exchange rate stability were marred by the markets but, for a number of months now, the core European cross rates have been remarkably stable. The next task is for interest rates to converge otherwise speculators will be offered a one-way bet. If, for example, French Francs offer a higher rate of return than Deutschemarks and traders know that there is unlikely to be any change in the relative exchange rates, there will be a wholesale switch out of Deutschemarks into francs.

The Bundesbank's move last week was the first step towards achieving this convergence. The perceived market wisdom is that, by next May when the potential Euro currencies come under starter's orders, European rates will have moved to 4.5 percent. Given that German, French, Dutch and Finnish 3 month inter-bank rates are currently around 3.5 percent and Spanish, Irish and Portuguese rates range between 5 and 7 percent, this implies further adjustments will be needed.

The problem with making these interest rate adjustments is that the underlying economies are still not moving in tandem. Pushing up German and French interest rates therefore risks sabotaging their economic recovery while in Ireland, Portugal and Spain reducing rates to a Euro average risks stoking up inflationary pressures.

This misalignment of economic conditions is likely to have serious social consequences. What is surprising is that Germany–the most recent example of two economies fusing to form a single currency bloc–has not extrapolated the problems currently being experienced in its eastern lander to a wider European context. September's unemployment figures showed that in Germany as a whole the number of jobless was 11.7 percent of the workforce but this masked a wide disparity between the former East and West Germany. In eastern Germany the figure is 19.2 percent whereas in the western lander it is only 9.9 percent. Instead of fusing economies together, Europe could find that monetary union pulls them apart.

Deborah Owen, Editor

The Dow Jones Industrial Average (DJIA) was first published in 1896 to help investors identify broad stock market trends, it has since become known as the “Dow”–the most widely quoted and followed benchmark for the U.S. stock market. The DJIA tracks the average price of 30 large NYSE stocks drawn from a cross section of sectors of the U.S. economy. The stocks in the DJIA are all household names and are heavily traded in the United States as well as in major foreign stock markets.

The DJIA portfolio consists of equal numbers of shares of each of the 30 stocks. The total market value of DJIA stocks was $2.125 trillion, as of June 1997. This represents approximately 25 percent of the market value of NYSE stocks and 20 percent of the market value of all U.S. stocks. Partly because of the vast value this basket of stocks represents, it is very difficult for individual investors to replicate exactly the performance of the Dow without owning shares in each of the 30 stocks that comprise the index–a potentially exorbitant expense.

The Chicago Board of Trade (CBOT) has now introduced both a futures and an options contract based on the Dow which will enable investors to trade the exact components of the DJIA.

Datastream

What Are DJIA Futures?

A CBOT DJIA futures contract, like all futures contracts, is an obligation to buy (a long position) or sell (a short position) a specific commodity–in this case, the basket of stocks represented by the DJIA index. A futures contract also specifies the date by which this transaction must occur, known as the settlement date, and how the transaction will be fulfilled, known as delivery. The level of the futures contract closely tracks the level of the DJIA index, but may be higher or lower due to the impact of several factors to be discussed below.

Value Of The Contract

The value of the futures contract is determined by multiplying the index level of the futures contract by $10. For example, if the futures index price is 7800, the value of the contract is 7800 x $10 = $78,000. As a buyer or seller of the futures contract, you are essentially trading approximately $78,000 worth of stock.

Method Of Settlement

CBOT DJIA futures settle (or are delivered) in cash, not in the actual basket of stocks comprising the index. This means that on the settlement date of the contract the settlement price is $10 times the special opening quotation, a value derived from the opening prices of the component stocks of the index following the last day of trading in the futures contract. This value can be compared to the price paid for the contract when the trade was initiated. For example, if the DJIA is 7900 at expiration, a long who bought the contract at 7800 receives $1,000 ($10 x 100) from the short.

This $1000, however, is not paid in one lump sum upon expiration of the contract, it is paid in successive installments of `margin' payments which begin on the date following the initial futures transaction and continue to the date of settlement (if the contract is held that long) or when the contract is offset by an opposite transaction. This is called marking to market. Daily margin payments are determined by the difference between the previous day's settlement price of the futures contract when it is bought or sold and the contract settlement price determined at the close of trading each day. Margin in the futures markets is not the same as margin in the equities markets, where it provides a form of leverage on your investments. In the futures markets, such payments “mark to market” the value of the futures contract and can be viewed as a performance bond, reducing the risk of default by either party to the transaction.

For example, if the settlement price of June CBOT DJIA futures increases from 7800 to 7840 between June 17 and June 18, the short pays $400 ($10 x 40 = $400) and the long receives $400. If the futures settlement price decreases 10 points the following day, the long pays $100 to the short–and so on until settlement, when the futures price and the index price converge and become equal.

Remember, once any required margin has been paid, the short or long can close out a position by offsetting the contracts. This makes a futures contract equivalent to a sequence of daily contracts an investor can interrupt at any time before settlement. At the settlement date, positions that have not been offset are settled in cash at the final settlement price. Of course, the dollar amount of margin due will be determined by changes in the price of the futures contract and the number of contracts bought or sold.

Buying And Selling The Market

With Long And Short Futures Contracts

To buy or sell DJIA futures is to buy or sell the DJIA portfolio at some future date. There are two differences between buying the DJIA portfolio and buying the futures:

1. The price of the portfolio must either be paid fully in cash or financed at the prevailing short-term rate of interest in a stock margin account.

2. The owners of the stocks receive cash dividends.

As mentioned earlier, the price of the futures contract closely tracks the price of the index; however, these two differences do have an effect on the futures price. To make the futures contract a true substitute for the index, it is priced to account for both the short-term financing of the stocks and the dividends paid by component stocks until futures expiration. This adjustment is called the cost of carry, and the price of the DJIA plus the cost of carry determines a fair value (theoretical value) for the futures contract.

The process by which the fair value of the futures contract to the cash index price is maintained is called arbitrage. Arbitrage refers to the simultaneous purchase (sale) of a futures contract and sale (purchase) of the stocks in the underlying index. If the cost of buying the DJIA portfolio and financing the purchase is less than the futures price, arbitragers buy the DJIA portfolio and sell the futures. In doing so, they bring the index and futures prices back in line. Conversely, if the futures price is less than the cost of shorting the stocks, arbitragers short stocks and cover it with a long position in futures. As the expiration date of the futures contract approaches and financing costs decrease, the futures price converges with the price of the DJIA. As previously noted, at expiration the price of the DJIA futures is equal to the Dow.

A position in stock index futures is an efficient method of controlling a portfolio's exposure to stock market risk. Each long or short DJIA futures contract effectively buys or sells 10 times the DJIA portfolio at the expiration date of the contract. For example, if you are anticipating a correction or downturn in the stock market, selling $200,000 worth of DJIA futures contracts effectively reduces your current investments in DJIA stocks by $200,000. If this is your forecast, why trade in the futures market when you can simply divest yourself of $200,000 worth of stocks? Recall that the futures price is equal to the value of the DJIA plus the cost of carry. One of the components of the cost of carry is a short-term or money market interest rate. By selling the futures contract, the $200,000 now earn the money market rate of return and you guarantee that the future value of your $200,000 investment in stocks will be today's futures price (assuming your portfolio is very similar to the DJIA). Your investment in stocks is now riskless, and your rate of return on this riskless investment is the money market component of the cost of carry. Through the futures transaction, you have decreased your percentage of wealth invested in stocks and increased your percentage of wealth invested in a money market asset. Your underlying asset, the DJIA stocks, remains unchanged, saving you the time and commission expense of selling this substantial portfolio. If your expectations of market performance prove correct, you have shielded the portfolio from loss and gained a money market rate of return.

Of course, buying stock index futures has the reverse effect, meaning that you increase your exposure to equities and decrease your exposure to the money market. Even if you have no prior equity exposure, the same strategies serve to establish a long or short equity position so that you can take advantage of market moves. Certainly, the same asset allocations and reallocations can be realized by directly buying and selling (shorting) the stocks themselves. Yet it is more expedient and far less expensive to trade stock index futures, particularly if you expect the market upturn or downturn to be short-lived. This is the reason fund managers routinely use stock index futures to change the mix of assets in their portfolios.

In short, the parallel movement between the DJIA futures and the index itself makes the futures an ideal way for you to create a proxy of the U.S. market and to restructure and manage the risk of DJIA portfolios, or more generally, portfolios of U.S. stocks. There is no initial investment (other than the initial margin you must post) and little default risk. With a single transaction, you can instantly move in and out of the market at any time and at lower transaction costs than if you had to buy or sell a whole basket of stocks.

Extract from `Advanced Strategies for Individual Investors' published by the Chicago Board of Trade.

It is now almost 12 months since the chairman of the U.S. Federal Reserve Bank, Alan Greenspan, issued his first warning on the “irrational over exuberance” of the U.S. stock market. At the time, the market's initial reaction was one of shock and a sharp fall was recorded. The effect was, however, temporary and the market quickly recovered its poise. In fact, in the subsequent period the market has gained 23 percent, despite two more warnings by Greenspan. The first, delivered in the Humphrey-Hawkins testimony in February resulted in an interest rate rise at the March FOMC meeting. The second was delivered last week in a testimony on the U.S. budget and was seen by many as heralding another interest rate rise at the FOMC meeting in November. So far, this warning has made the market sensitive to stronger than expected economic data but has not caused any wholesale panic. With the anniversary of the 1987 stock market crash so near, it obviously raises the question of whether the U.S. stock market's long bull run may be nearing its end.

Technically, the underlying trend for the Dow Jones is firmly up, the current trend having been in place since July 1996. The trendline is some way below the market at 7166.2. The price action since July of this year has been consolidative in nature and can be seen either as a pause before another rally or as a potential top formation. The jury will remain out until certain key levels are broken. For the bull case to remain in the ascendancy, the old high of 8299.4 would have to be broken, in which case this would confirm the break-out of the consolidation and target a move to 8997.3 at least.

The current price action could also be viewed as a double top formation based around a neckline at 7573.9. A move below this level would confirm that a short-term top at least had been seen and target a move to 6862.2. Yet in the process of this move the 200-day moving average at 7359.3 would be broken, as would the underlying uptrend line at 7166.2. This would turn market sentiment significantly more bearish than at present and would also represent a correction of more than 10 percent, which is the traditionalists' view of a correction within a bull run in the equity markets. A move below 6862.2 would then target the major support at 6352.7, which is very close to a 61.8 percent retracement of the whole move from July 1996 to the all-time high.

In Tokyo there can be no doubt that the authorities underestimated the impact on the economy of the one percent sales tax rise imposed in April. Domestic economic recovery was halted dead in its tracks, followed soon afterwards by the Nikkei Dow index. The stock market rally came to an end in June and was followed by an equally steep decline. The chart of the Nikkei shows the price action moving within a steep, narrow downward channel, which is itself within a much broader downward channel. The top of the narrow channel is currently at 17,896.1 and it is possible in the short term that the index may rally through the top of this channel–in which case the objective would be 19,004, close to the present 200-day moving average at 18,973.6. These levels are likely to contain any rally, as the main thrust of the medium term still appears to be a move to lower levels.

The medium-term objective is the bottom of the broad channel at 15,589.3, which is falling at the rate of 15 points per day. This puts the current objective firmly in the middle of the gap left in July 1995 between 15,890 and 15,256 and which now appears likely to be filled. There is a second gap between 14,795 and 14,519 relating to the same period and this too could be filled. There is major support just below this level at 14,309–relating to a low seen in 1992 as well as the one in 1995–and at the moment this is not expected to be broken.

David Cocker

October 20, 1997 Berkeley Futures, Ltd.

38 Dover Street, London, UK, W1X 3RB

Consensus National Futures and Financial On Line Index

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