Strategy index

Strategy Indices

These are indices that track the performance of an algorithmic trading strategy. The algorithm clearly and transparently specifies all the actions that need to be taken. The following are examples of algorithms that strategies can be based on.

1) Pairs Trading Strategy. This strategy examines pairs of instruments that are known to be statistically correlated. For example, consider Shell and Exxon. Both are oil stocks and are likely to move together. Knowledge of this trend creates an opportunity for profit, as on the occasions when these stocks break correlation for an instant, the trader may buy one and sell the other at a premium.

2) Fed Funds Curve Strategy This strategy takes a view on the shape of the curve based on the actions of the Fed. In this strategy, one puts on a steepener or flattener, based on whether the Federal Reserve has cut the benchmark rate or raised it. This is based on the conventional wisdom that the curve steepens when the rate is expected to be cut and vice versa.

3) Implied Volatility against Realized Volatility In a number of markets such as commodities and rates, the implied volatility, as implied by straddle prices is higher than the realized volatility of the underlying forward. One way to 'exploit' this is to sell a short expiry straddle on day 1 and delta-hedge the straddle every day. The strategy makes money if at expiry, the premium received, the final value of the straddle and the final value of the forwards is greater than zero.

Selling Strategy Indices

These indices have been sold under the following premises which need not be always true,

1. They offer a new asset class that is uncorrelated to conventional asset classes such as equities, bonds and commodities. 2. Compared to hedgefunds and mutual funds, these strategies are very transparent and the client can buy them only if they like the idea behind the strategy. 3. Some types of strategies also benefit from accounting reasons, for instance, in Germany, Notes linked to interest rates can be issued in the Schuldshein format. This enables interest rate linked strategies to be issued as Schuldsheins.

Financial Institutions that have bought these products
Several Institutional clients and mid-cap corporates have purchased products based on these strategies. Some major clients include:
Kaupthing (The now nationalized icelandic bank) LandBanski (The now nationalized icelandic bank) Pension Funds in Germany and Netherlands such as NAEV and Shell Metro Lisbon

Financial Institutions selling these products
A number of major investment banks have dedicated strategy index trading businesses or are looking to establish one. These desks usually work under the exotic derivatives umbrella at each bank. As a result, it is difficult to establish exactly how much strategy index trading generates at each bank. UBS and Deutsche Bank are generally regarded to be leaders in this business with Morgan Stanley, Barclays, RBS, Lehman (Now Nomura) all looking to quickly establish themselves in this business. Considering that it is possible to charge upto 2% annually on these trades, with the usual charge being 1% running, the revenues on a typical 5y strategy trade are 5-10 times that of a conventional exotic trade.