Basics: A template for Inter-City spreads

I mentioned in an earlier blog that Inter-City spread markets might be a good opportunity to express relative value views, and to promote trading.   While the CME website has a pull-down menu that shows inter-city quotes (click here), they sometimes include what I describe as automatically generated “Arb markets” in their display.

An “Arb” inter-city bid results from pairing the outright bid of the front contract with the outright offer of the second contract, and an inter-city offer results from pairing the outright offer of the front contract with the outright bid of the second contract.  For example, if the CUSX12 market is 159.0/161.0 and the LAX12 market is 175.0/176.0, the the inter-city CUS/LAX X12 arb markets would be -17/ -14.  The -17 inter-city bid is the 159 CUS bid minus the 176 LAX offer, while the -14 inter-city offer is the 161 CUS offer minus the LAX 175 bid.  (Note that the “Arb” inter-city bid/ask spread (3 points here) is the combination the bid/ask spreads on each of the two underlying contracts.)

As such, a -17/-14 quote, by itself, doesn’t tell you if someone is bidding the inter-city spread.   A trader would need to test all inter-city bids and offers to see if there is a real inter-city bid (or offer) at better than “Arb” levels.  This table does that.

The table shows the results of filtering all inter-city quotes for the Nov ’12 markets that are better than arbitrage levels and highlights those markets in the Mkts* line.  The degree to which an inter-city bid is better than the arbitrage level is shown in yellow.

So while there are 55 possible pairs where quotes are shown on the CME website (all shown), one can see that there are only 8 pairs that have at least one inter-city quote that is better than “Arb” levels.  Five pairs have CUS on one side of the trade, but there are also quotes for BOS/NYM, BOS/WDC and LAX/SDG.  (Note that with the exception of CUS, the front contract is the one that comes first alphabetically).

The BOS/NYM quote of -8.0/-7.0 is both the tightest inter-city quote (at 1.o point) but also the only where both sides are inside arbitrage levels.  (Recall from above that if both BOS and NYM have 1.2 bid/ask spreads, that the BOS/NYM inter-city arb level should have a 2.4 bid/ask spread.  It is only 1 point because the bid is 0.2 inside arb levels and the offer is 1.2 inside the arb level, which combine to reduce the inter-city bid/ask spread by 1.4 points.

This approach might lead to discussions of what pairs traders might want to see.  All regional contracts can be compared to CUS to express a view on the relative strenght of a region versus the 10-city index, (or to hedge the incremental performance of a region).  Regional pairs (e.g. BOS/NYM, LAX/SDG) should be highly correlated and might make sense for hedging, and one might express a view on judicial friendly versus “slow workout” regions.

In looking at other expirations,  I don’t see any non-arb inter-city quotes today.  (I’ll try to post if/as I see them.)

Please feel free to contact me if you have any questions on the table, or any interest in discussing ideas for inter-city spread trades at johnhdolan@homepricefutures.com.