"We are not in Kansas Anymore?" Waddell & Reed and the Dow's 1000 Point Drop

May 18th, 2010
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Contributed by: Aswath Damodaran
It looks like that they have found the culprit for the 1000-point intraday swing on the Dow 30 on May 6. It turns out that rather than the hedge funds that were initially suspected, it was a Kansas-based money management firm, Waddell & Reed Financial, that traded 75000 e-mini S&P 500 contracts between 2.32 and 2.51 pm on May 6. That amounted to 9% of the trading volume on e-mini contracts during that period and all of the trading was executed by one trader at the firm. Incidentally, the CME report that uncovered this news also found that neither the trader nor the firm were acting imprudently or were at fault. This news item may still leave you a little bemused. How does one trader at a small money management firm cause a drop in market value of billions? And how can they not be at fault if they caused a market collapse? So, here is my attempt at providing an explanation.

What are e-mini contracts?
E-mini contracts are future contracts on the S&P 500. The "mini" in the name refers to the fact that each contract is $50 times the level of the index. (If the S&P 500 is at 1200, each contract is for a notional value of $60,000) E-mini contracts were introduced in the late 1990s by the Chicago Mercantile Exchange to provide a "smaller size" alternative to the long-standing S&P 500 futures contracts which were set to $500 times the level of the index; they have since been dropped to $250 times the level of the index.

How do investors use these contracts?
As with all futures contracts, there are speculators and hedgers in the e-mini market. The speculators buy or sell the e-mini to try to profit from overall market movements. Thus, a bullish (bearish) investor will buy (sell) e-mini contracts and make money if they are right on market direction. (If you buy 100 contracts and the S&P 500 moves up 80 points, you will make 100* 80 * 50 = $400,000; the 50 refers the fact that the futures contract is $50 times the index) The hedgers use the index to protect existing portfolio positions. Thus, a portfolio manager who wants to either protect profits already made or one who desires a floor on his or her losses will sell e-mini futures. (A portfolio manager who has $ 1 billion in equities can sell enough futures contracts to ensure that the value of the position does not drop below $ 900 million. Generally speaking, the more insurance you want, the more futures contracts you will have to sell. In more technical terms, you are creating a synthetic put on your portfolio, using options, and the number of futures contracts you will need to sell can be extracted using an option pricing model)

In many ways, the hedging position with futures is a lot more volatile than the speculative position, simply because the degree of selling is tailored to what the index does. As the index falls, the selling will often accelerate. partly because the point at which different portfolio managers hedge can vary. Thus, some portfolio managers may begin their hedging when the market drops 3%, others at 5% and still others at 10%.

How can futures affect the level of the index?
With financial futures, there is a third player that we have not mentioned in the section above, the arbitrageurs. Arbitrageurs have neither a market view nor do they have a portfolio to hedge. Instead, they are looking to make riskless profits, To prevent these profits, the futures price and the spot price are linked together in a rigid relationship:
Futures Price = Spot price (1 + riskfree rate - dividend yield)

To see why, assume that the S& P 500 is at 1000 right now, that the riskfree rate is 5% and that the dividend yield is 2%. Assume also that the one-year futures price on the index is 1045. Here is the arbitrage:
1. Borrow 1000 at the riskless rate and buy the index today at its spot price of 1000.
2. Sell the one-year futures contract at 1045.
3. During the next year collect dividends on the stocks in the index (2% of 1000 = 20). At the end of the year, deliver the stocks in the index in fulfillment of the futures contract and collect 1045. Pay the interest at the riskfree rate on the initial borrowing of 1000 (from step 1) and pocket the difference:
Profit = 1045 - 1000*.05 +20 = 15
To prevent this profit from occurring, the futures price has to be 1030. There are points at which you can quibble - being able to borrow at the riskfree rate and knowing the dividends for the next year - but they are minor ones, especially for the larger institutional players. The overall dividend yield on the S&P 500 index is very predictable and you can borrow at close to the riskfree rate, especially if you can back the borrowing up with marketable securities (as is the case here).

This futures-spot relationship creates the link. If one (spot or futures price) moves, the other has to follow. Thus, if there is an imbalance in the futures market, the futures price will change and the spot will follow. On May 6, here is how the script unfolded. The sell order placed by the trader at Waddell and Read was large enough to cause the e-mini futures price to drop significantly and the spot market had to follow. The fact that the trade was entirely driven by liquidity or hedging concerns (and not by information) resulted in a swift correction of both the spot and futures markets, with both reversing the losses by 3.30 pm.

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