If inter-city spread trades are going to be a focus for 2013 then it might help to explain what they mean. That was the “constructive criticism” from one reader. Point noted.
Let me use a rivalry that New York traders might relate to: New York vs. Boston. After all saying that the BOS/NYMX15 spread is -12.0/-8.0 doesn’t convey much. The spot indices and futures contracts trade at different levels so the question is how can one translate an intercity quote into something more relevant. The answer is that just as with calendar spreads, intercity quotes can be translated into relative HPA comparisons.
The table (to the right) shows how one might evaluate the BOS/NYMX15 intercity spread. Recall that all spreads are quoted front value versus back and that most intercity spreads (except the CUS/HCI 10-city index) are shown in alphabetical order. Thus one would talk about BOS/NYM, not NYM/BOS.
That table shows the spot levels and Nov 2015 markets for both BOS and NYM. The mid of the BOSX15 market 172.7 is shown and the percent of that number over the spot value (150.6) is also shown (14.65%). Thus one might say that the mid-market quote for the BOSX15 contract is consistent with a rise of ~14.6% in the BOS Case Shiller index by the Nov 2015 release.
The intercity bid (-12.0) and intercity offer (-8.0) would be equivalent to OFFERS on NYM of 184.7 and BIDS of 180.7 when compared to the BOS mid-market. I’ve added emphasis and color-coded the prices to remind readers that an intercity bid is the difference between a bid on the front contract combined with an offer on the back contract. Thus the -12.0 bid would be consistent with a 172.7 bid for BOS and an OFFER of 184.7 on NYM. Similarly, the -8.0 intercity offer is consistent with a 172.7 offer on BOS and a BID for NYM at 180.7.
Given these “implied” 180.7/184.7 quotes on the NYMX15 contract, price relative to spot can be calculated in the same way as BOS above. The implied 180.7 NYMX15 bid is consistent with a rise of 12.83% over NYM spot (160.15) while the implied 184.7 NYMX15 offer is consistent with a rise of 15.33% over the NYM spot.
By comparing the 14.65% rise in the BOSX15 contract with the 12.83%/15.33% rises implied by the intercity derived NYMX15 quotes one can translate the -12.0/-8.0 intercity BOS/NYM quotes into something that says “the intercity seller is quoting a level where BOS will outperform NYM by 1.82%, while the intercity bidder is quoting a level where BOS will outperform NYM by -0.68% (so under-perform)”.
One can take implied out-/(under-/performance and solve back for intercity quotes that would be consistent with one’s views. In the table I’ve reversed the algebra to solve for the level where BOS would out-perform NYM by at least one point -any intercity quote wider than 12.5 points. Similarly, one can solve for the level at which a seller of the intercity quote (selling the front contract relative to the back) would see NYM under-performing BOS by at least 1% or -9.3 points.
Net, the -12.0/-8.0 quote is consistent with a view where the bidder believes that BOS will outperform NYM by almost 2 percent, and the offer is consistent with the view that the seller believes that NYM will underperform BOS by only a small amount.
Of course, any combination of regions and expiration is possible and total over/under-performance can also be translated back into implied HPA differences.
Note that the -12.0/-8.0 intercity market at four points is tighter than either outright market (12.6 points on BOS and 9.0 for NYM) and MUCH tighter than an “arbitrage” market of the two contracts (-18.6/3.0 or 21.6 points, or the combination of the two outright bid/ask spreads). This is the relative attractiveness of intercity spreads as a way to potentially develop market interest. Recall that an intercity trade results in limited outright market risk (the notional values aren’t the same, an issue that would be most pronounced in an LAV/WDC quote), and no calendar risk. Since BOS and NYM (much like LAX and SDG) are also highly correlated (see upcoming blog) the risk of one contract moving very different from another is reduced.
Net, one can take a view on RELATIVE movements between two regions for a fraction of the risk of the outright risk on either region (particularly if the two regions are highly correlated).
I’m open to discussing this blog, and any other combination of intercity quotes. Feel free to contact me at email@example.com.