SGX Market Strategist, Equity & Fixed Income, Singapore Exchange Ltd (SGX)

Geoff Howie

SGX Market Strategist, Equity & Fixed Income

Asia’s leading multi-asset exchange

Singapore Exchange Ltd (SGX)

Singapore Exchange is Asia’s leading and trusted market infrastructure, facilitating the exchange of capital and ideas to create value for people, businesses and economies. As a multi-asset exchange operating equity, fixed income and derivatives markets to the highest regulatory standards, SGX is a vertically integrated business that provides listing, trading, clearing, settlement, depository and data services.

With about 40% of listed companies and over 80% of listed bonds originating outside of Singapore as well as established linkages across the region and in Europe, SGX is Asia’s most international and connected exchange. Offering a full suite of derivatives products across Asian equity indices, commodities and currencies, SGX is the world’s most liquid international market for the benchmark equity indices of China, India, Japan and ASEAN.

As Asia’s pioneering central counterparty, SGX is globally recognised for its risk management and clearing capabilities, and was one of the first globally to adopt the Principles for Financial Market Infrastructure.

Headquartered in AAA-rated Singapore, SGX has over 800 employees including offices in Beijing, Chicago, Hong Kong, London, New York, Mumbai, San Francisco, Shanghai and Tokyo.

Equity Bottom-Up

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<ul>
<li>Index arbitraging activities between SGX MSCI Singapore (SiMSCI) futures and SGX cash markets at a multi-year high of almost S$500 million 
	 </li>
	<li>Greater synchronisation and correlation between price of futures and the underlying stocks across various intraday timeframes 
	 </li>
	<li>Plans to launch Single Stock Futures on selected MSCI Singapore Free Index stocks to enable international market participants to execute different arbitrage strategies</li>
</ul>
Introduction

The MSCI Singapore Free Index is the benchmark index for the Singapore equities market. The index comprises 25 blue-chip stocks listed on the Singapore Exchange (SGX), and covers 85% of total free-floated adjusted market capitalisation of the Singapore exchange-listed equity universe. In 1998, SGX launched the <a href="https://www.sgx.com/derivatives/products/sgxsimsci?cc=SGP">SGX MSCI Singapore Index Futures</a> (“SiMSCI Futures”) to help market participants get quick and efficient access to the Singapore exchange-listed equity market, while allowing them to hedge their exposure of SGX-listed stocks.

In the decades since, the market for the SiMSCI Futures has grown to trade an average of S$1.9 billion notional value daily, with participants collectively holding S$6.5 billion of notional open interest (for the month of Feb 2020). The market for the SiMSCI Futures has attracted a wide range of market participants, from professional trading groups to investment banks and asset managers from around the world.

Many of these participants engage in arbitrage activity between the SiMSCI Futures, and the 25 constituents of the MSCI Singapore Free Index (“underlying stock basket”). This arbitrage activity keeps futures and stock prices in line, and creates a shared liquidity pool across both asset classes. In the first quarter of 2020, SGX noted a marked increase in daily turnover in the securities market (“SDAV”) due to increased volatility from the emerging pandemic, and a large part of this increase was directly caused by increased arbitrage activity.

One remarkable consequence of the increased arbitrage activity during this time was evidence by the prices of the underlying stock basket moving in tighter lockstep with SiMSCI Futures prices, when viewed on a 15-minute intraday sampling interval. The underlying stock basket also shown an improvement in the price leadership (from 17% to 24%) as well as price discovery power (19% to 26%) in March 2020 over the previous month. The third part in this article covers these market changes in more detail.

SGX proposes to launch Single Stock Futures on selected MSCI Singapore Free Index stocks (“Singapore SSFs”) in the coming months subject to regulatory approval. It envisions that Singapore SSFs will draw the interest of the international participants of our derivatives market to the stock market, and in doing so add another leg to the existing arbitrage between the index futures and underlying stock basket. In the fullness of time, a liquid Singapore SSFs market will add a layer of improved efficiency to the index arbitrage trade due to a product microstructure that is distinct from that of the underlying stocks.

Classic index arbitrage

In a classic index arbitrage trading strategy, the arbitrageur will enter into paired positions holding the index futures contract and basket of underlying index stocks when the arbitrageur notices a large-enough relative price dislocation between the two. The arbitrageur then typically carries these paired positions until the expiration of the futures contract, and that is when the arbitrageur will unwind the stock basket at the point of determination of the futures contract’s Final Settlement Price (“FSP”). This is done to achieve convergence of the futures expiration price and the price of the unwound underlying stock basket.

[Figure 1 – Traded value of index constituents in the Opening Auctions March 2019 – March 2020]
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<figure>
 <img src='https://api2.sgx.com/sites/default/files/2020-04/30%20Apr%20%281%29.png' alt='Traded Value' />
 </figure>
 <div class='content-caption'>Traded Value</div>
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The SiMSCI Futures expire and settle to the Special Quotation as calculated by MSCI using the opening prices of the underlying index stocks on the last business day of the month. Therefore, arbitrageurs will unwind their stock positions in the Opening Auction on the SiMSCI Final Settlement Day, as explained earlier. Figure 1 above shows the historical traded values of the Opening Auctions for past one year, where it is obvious that the spikes in traded value on SiMSCI Final Settlement Days over other trading days are the direct result of unwinding activity by index arbitragers.

[Figure 2 – Weightage of top seven constituents’ traded values]
</body></html>

<figure>
 <img src='https://api2.sgx.com/sites/default/files/2020-04/30%20Apr%20%282%29.png' alt='weightage' />
 </figure>
 <div class='content-caption'>weightage</div>
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As in Figure 2, SGX also found that the traded value of the seven major stocks  of the MSCI Singapore Free Index closely follow the actual MSCI Singapore Free Index composition and component weightage (For legal reasons, SGX is unable to reproduce MSCI Singapore Free Index weightages here. Please obtain weightage data directly from MSCI Inc.) in each calendar month, further lending credence to the existence and growth of index arbitrage activity in the SGX stock market.

Cost factors in index arbitrage 

Index arbitrageurs incur various costs when executing their trading strategies:

<ol>
<li>Spread cost: this is incurred when crossing the bid-offer spread when trading the futures contract, and the underlying stock basket. This cost is realised when arbitrageurs exit their position. 
	 </li>
	<li>Transaction cost: this is incurred when using a broker to execute trades and using the exchange for central limit order book price discovery and clearing. This cost is applicable for both enter and exit. 
	 </li>
	<li>Market slippage cost: this is incurred when executing an order that is too large for the prevailing best bid or best offer to absorb. This cost is applicable when enter and exit a position. 
	 </li>
	<li>Stock borrow cost: this is incurred when opportunistically shorting the index stock basket against a long futures position. From December 2019, SGX has put into place a revised <a href="https://www.sgx.com/securities/depository#Securities%20Borrowing%20and%20Lending">Securities Borrowing and Lending (“SBL”) programme</a> that makes it much more cost-efficient for market participants to borrow index stocks (amongst others) from SGX’s available lending pool.</li>
	<li>
	SGX has provided an estimate of the cost components (excluding broker commissions, which vary depending on market participants) in the following table.
	</li>
</ol>
 [Figure 3 – Estimated Cost components in arbitrage strategies as of 31st March 2020]

<table class="table table-striped"><tbody>
<tr>
<td>
			Cost Components
			</td>
			<td>
			Index Point
			</td>
			<td>
			Basis Point
			</td>
		</tr>
<tr>
<td>
			Cash basket Bid-Offer Spread
			</td>
			<td>
			0.8
			</td>
			<td>
			28.0
			</td>
		</tr>
<tr>
<td>
			Futures Bid-Offer Spread
			</td>
			<td>
			0.05
			</td>
			<td>
			1.7
			</td>
		</tr>
<tr>
<td>
			Clearing Fee (round trip) for Cash leg
			</td>
			<td>
			N.A
			</td>
			<td>
			6.5
			</td>
		</tr>
<tr>
<td>
			Trading Fee (round trip) for Cash leg
			</td>
			<td>
			N.A
			</td>
			<td>
			1.5
			</td>
		</tr>
<tr>
<td>
			Clearing Fee (round trip) for Futures leg
			</td>
			<td>
			0.04
			</td>
			<td>
			1.4
			</td>
		</tr>
<tr>
<td>
			Market Slippage (S$6M Basket Notional)
			</td>
			<td>
			0.54
			</td>
			<td>
			18.6
			</td>
		</tr>
<tr>
<td>
			Borrowing Rate (to short cash) per Month
			</td>
			<td>
			N.A
			</td>
			<td>
			2.0 – 5.0
			</td>
		</tr>
</tbody></table>
 With these cost considerations in mind, an index arbitrageur would need a large-enough relative price dislocation between the futures contract and the underlying stock basket before it is able to enter into a profitable trade. In the following chart, the blue line is the difference between future prices over underlying stock basket prices after adjusting dividend component and discount factor from interest rate. In theory, its theoretical values should be zero and any fluctuations around the theoretical values are representing opportunities for index arbitraging. However, after taking into account the costs (excluding broker commissions), there is a distinct no-arbitrage zone of approximately +/- 58 basis points or +/- 1.7 index points wide, outside of which an attempted arbitrage trade would have the potential to be profitable.

[Figure 4 – No arbitrage zone using daily observations from March 2019 – March 2020]
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<figure>
 <img src='https://api2.sgx.com/sites/default/files/2020-04/30%20Apr%20%283%29.PNG' alt='No arbitrage zone' />
 </figure>
 <div class='content-caption'>No arbitrage zone</div>
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Market changes in heightened volatility environment

As volatility returned to the market in March 2020, together with a surge in daily trading values in both cash and futures market, index arbitrage activity also climbed to its multi-year high at S$457M for the month.  We observed that there were significant improvements in the correlations between futures and the underlying stock basket across various intraday timeframes.

[Figure 5 – Intraday correlation between SiMSCI futures and underlying stock basket]
</body></html>

<figure>
 <img src='https://api2.sgx.com/sites/default/files/2020-04/30%20Apr%20%284%29.png' alt='Intraday Correlation' />
 </figure>
 <div class='content-caption'>Intraday Correlation</div>
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<html><body>
Prior to 2020, SiMSCI Futures prices and underlying stock basket prices exhibited positive but relatively weak correlation between the range of 20% to 77% when sampled for intervals 45 minutes or shorter (an effect visualised by the orange line in the above chart). This implies that it takes up to 45 minutes for price dislocations between futures and stock basket to be exploited by index arbitrageurs to the point of convergence. This also suggests that a large part of the price dislocations lie within the no-arbitrage zone.

With the spike in volatility and trading activity in March 2020, we note that the intraday correlation had improved dramatically across various timeframes, achieving 93% correlation even at a 15-minute sampling interval (as visualised by the blue line in the above chart). This implies that index arbitrageurs were able to find more price dislocations outside of the no-arbitrage zone to exploit, thereby bringing the futures prices and underlying stock basket prices in line more quickly.

Considering SiMSCI Futures and the underlying stock basket being two strongly correlated assets, Figure 6 shows how fast investors are able to incorporate news into market prices (“price leadership”) and how much these prices contribute toward the fair prices (“price discovery”) of the underlying stock basket relatively over the futures market in February and March 20201. SGX found that the price leadership of the underlying stocks improved sharply from 17% to 24% in the particularly volatile month of March 2020, while the price discovery power similarly improved from 19% to 26%. The larger price movements during this time potentially led to higher price leadership of stock basket, while the increase in price discovery indicates that higher intraday arbitraging activities helped bring stock basket closer to the fair prices during the trading day.

Note: [1] For more details on the concepts of price leadership and price discovery power please read Price Discovery and Common Factor Models article in Journal of Financial Markets, Feb 2002 by Richard T.Baillie, G. Geoffrey Booth and Yiuman Tse

[Figure 6 – Price leadership and discovery of underlying stock basket]
</body></html>

<figure>
 <img src='https://api2.sgx.com/sites/default/files/2020-04/30%20Apr%20%285%29.png' alt='Price Leadership' />
 </figure>
 <div class='content-caption'>Price Leadership</div>
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Singapore SSFs to empower price discovery

Earlier in Figure 3 of this article, we provided an estimate of the costs to an index arbitrageur. The largest cost component is the crossing of the bid-offer spread in the underlying stock basket. We now show the individual component stock contributors to the stock basket bid-offer spread cost, with the top 3 contributors being Singtel (16%), Genting (10%), and OCBC (7%).

 

[Figure 7: Bid-Offer Spread contributors into overall SiMSCI basket Bid-Offer Spread]
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<figure>
 <img src='https://api2.sgx.com/sites/default/files/2020-04/30%20Apr%20%286%29.png' alt='SSF' />
 </figure>
 <div class='content-caption'>SSF</div>
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In launching the Singapore SSFs on these principle components of the MSCI Singapore Free Index, market participants will be able to trade with a different market microstructure (narrower tick sizes), with the potential to reduce the bid-offer spread cost of executing index arbitrage strategies. This is naturally predicated on a certain base level of liquidity in the Singapore SSFs that will develop in time with the entrance of more international participants from the derivatives space.

Subject to regulatory approval, SGX plans to list Singapore SSFs to enhance the interaction between its securities and derivatives markets and thereby providing efficiency and price discovery for market participants. 
</body></html>




Index arbitraging activities between SGX MSCI Singapore (SiMSCI) futures and SGX cash markets at a multi-year high of almost S$500 million 
	 
	Greater synchronisation and correlation between price of futures and the underlying stocks across various intraday timeframes 
	 
	Plans to launch Single Stock Futures on selected MSCI Singapore Free Index stocks to enable international market participants to execute different arbitrage strategies

Introduction

The MSCI Singapore Free Index is the benchmark index for the Singapore equities market. The index comprises 25 blue-chip stocks listed on the Singapore Exchange (SGX), and covers 85% of total free-floated adjusted market capitalisation of the Singapore exchange-listed equity universe. In 1998, SGX launched the SGX MSCI Singapore Index Futures (“SiMSCI Futures”) to help market participants get quick and efficient access to the Singapore exchange-listed equity market, while allowing them to hedge their exposure of SGX-listed stocks.

In the decades since, the market for the SiMSCI Futures has grown to trade an average of S$1.9 billion notional value daily, with participants collectively holding S$6.5 billion of notional open interest (for the month of Feb 2020). The market for the SiMSCI Futures has attracted a wide range of market participants, from professional trading groups to investment banks and asset managers from around the world.

Many of these participants engage in arbitrage activity between the SiMSCI Futures, and the 25 constituents of the MSCI Singapore Free Index (“underlying stock basket”). This arbitrage activity keeps futures and stock prices in line, and creates a shared liquidity pool across both asset classes. In the first quarter of 2020, SGX noted a marked increase in daily turnover in the securities market (“SDAV”) due to increased volatility from the emerging pandemic, and a large part of this increase was directly caused by increased arbitrage activity.

One remarkable consequence of the increased arbitrage activity during this time was evidence by the prices of the underlying stock basket moving in tighter lockstep with SiMSCI Futures prices, when viewed on a 15-minute intraday sampling interval. The underlying stock basket also shown an improvement in the price leadership (from 17% to 24%) as well as price discovery power (19% to 26%) in March 2020 over the previous month. The third part in this article covers these market changes in more detail.

SGX proposes to launch Single Stock Futures on selected MSCI Singapore Free Index stocks (“Singapore SSFs”) in the coming months subject to regulatory approval. It envisions that Singapore SSFs will draw the interest of the international participants of our derivatives market to the stock market, and in doing so add another leg to the existing arbitrage between the index futures and underlying stock basket. In the fullness of time, a liquid Singapore SSFs market will add a layer of improved efficiency to the index arbitrage trade due to a product microstructure that is distinct from that of the underlying stocks.

Classic index arbitrage

In a classic index arbitrage trading strategy, the arbitrageur will enter into paired positions holding the index futures contract and basket of underlying index stocks when the arbitrageur notices a large-enough relative price dislocation between the two. The arbitrageur then typically carries these paired positions until the expiration of the futures contract, and that is when the arbitrageur will unwind the stock basket at the point of determination of the futures contract’s Final Settlement Price (“FSP”). This is done to achieve convergence of the futures expiration price and the price of the unwound underlying stock basket.

[Figure 1 – Traded value of index constituents in the Opening Auctions March 2019 – March 2020]



      
    
    Traded Value


The SiMSCI Futures expire and settle to the Special Quotation as calculated by MSCI using the opening prices of the underlying index stocks on the last business day of the month. Therefore, arbitrageurs will unwind their stock positions in the Opening Auction on the SiMSCI Final Settlement Day, as explained earlier. Figure 1 above shows the historical traded values of the Opening Auctions for past one year, where it is obvious that the spikes in traded value on SiMSCI Final Settlement Days over other trading days are the direct result of unwinding activity by index arbitragers.

[Figure 2 – Weightage of top seven constituents’ traded values]



      
    
    weightage


As in Figure 2, SGX also found that the traded value of the seven major stocks  of the MSCI Singapore Free Index closely follow the actual MSCI Singapore Free Index composition and component weightage (For legal reasons, SGX is unable to reproduce MSCI Singapore Free Index weightages here. Please obtain weightage data directly from MSCI Inc.) in each calendar month, further lending credence to the existence and growth of index arbitrage activity in the SGX stock market.

Cost factors in index arbitrage 

Index arbitrageurs incur various costs when executing their trading strategies:


Spread cost: this is incurred when crossing the bid-offer spread when trading the futures contract, and the underlying stock basket. This cost is realised when arbitrageurs exit their position. 
	 
	Transaction cost: this is incurred when using a broker to execute trades and using the exchange for central limit order book price discovery and clearing. This cost is applicable for both enter and exit. 
	 
	Market slippage cost: this is incurred when executing an order that is too large for the prevailing best bid or best offer to absorb. This cost is applicable when enter and exit a position. 
	 
	Stock borrow cost: this is incurred when opportunistically shorting the index stock basket against a long futures position. From December 2019, SGX has put into place a revised Securities Borrowing and Lending (“SBL”) programme that makes it much more cost-efficient for market participants to borrow index stocks (amongst others) from SGX’s available lending pool.
	
	SGX has provided an estimate of the cost components (excluding broker commissions, which vary depending on market participants) in the following table.
	

 [Figure 3 – Estimated Cost components in arbitrage strategies as of 31st March 2020]




			Cost Components
			
			
			Index Point
			
			
			Basis Point
			
		


			Cash basket Bid-Offer Spread
			
			
			0.8
			
			
			28.0
			
		


			Futures Bid-Offer Spread
			
			
			0.05
			
			
			1.7
			
		


			Clearing Fee (round trip) for Cash leg
			
			
			N.A
			
			
			6.5
			
		


			Trading Fee (round trip) for Cash leg
			
			
			N.A
			
			
			1.5
			
		


			Clearing Fee (round trip) for Futures leg
			
			
			0.04
			
			
			1.4
			
		


			Market Slippage (S$6M Basket Notional)
			
			
			0.54
			
			
			18.6
			
		


			Borrowing Rate (to short cash) per Month
			
			
			N.A
			
			
			2.0 – 5.0
			
		

 With these cost considerations in mind, an index arbitrageur would need a large-enough relative price dislocation between the futures contract and the underlying stock basket before it is able to enter into a profitable trade. In the following chart, the blue line is the difference between future prices over underlying stock basket prices after adjusting dividend component and discount factor from interest rate. In theory, its theoretical values should be zero and any fluctuations around the theoretical values are representing opportunities for index arbitraging. However, after taking into account the costs (excluding broker commissions), there is a distinct no-arbitrage zone of approximately +/- 58 basis points or +/- 1.7 index points wide, outside of which an attempted arbitrage trade would have the potential to be profitable.

[Figure 4 – No arbitrage zone using daily observations from March 2019 – March 2020]



      
    
    No arbitrage zone


Market changes in heightened volatility environment

As volatility returned to the market in March 2020, together with a surge in daily trading values in both cash and futures market, index arbitrage activity also climbed to its multi-year high at S$457M for the month.  We observed that there were significant improvements in the correlations between futures and the underlying stock basket across various intraday timeframes.

[Figure 5 – Intraday correlation between SiMSCI futures and underlying stock basket]



      
    
    Intraday Correlation


Prior to 2020, SiMSCI Futures prices and underlying stock basket prices exhibited positive but relatively weak correlation between the range of 20% to 77% when sampled for intervals 45 minutes or shorter (an effect visualised by the orange line in the above chart). This implies that it takes up to 45 minutes for price dislocations between futures and stock basket to be exploited by index arbitrageurs to the point of convergence. This also suggests that a large part of the price dislocations lie within the no-arbitrage zone.

With the spike in volatility and trading activity in March 2020, we note that the intraday correlation had improved dramatically across various timeframes, achieving 93% correlation even at a 15-minute sampling interval (as visualised by the blue line in the above chart). This implies that index arbitrageurs were able to find more price dislocations outside of the no-arbitrage zone to exploit, thereby bringing the futures prices and underlying stock basket prices in line more quickly.

Considering SiMSCI Futures and the underlying stock basket being two strongly correlated assets, Figure 6 shows how fast investors are able to incorporate news into market prices (“price leadership”) and how much these prices contribute toward the fair prices (“price discovery”) of the underlying stock basket relatively over the futures market in February and March 20201. SGX found that the price leadership of the underlying stocks improved sharply from 17% to 24% in the particularly volatile month of March 2020, while the price discovery power similarly improved from 19% to 26%. The larger price movements during this time potentially led to higher price leadership of stock basket, while the increase in price discovery indicates that higher intraday arbitraging activities helped bring stock basket closer to the fair prices during the trading day.

Note: [1] For more details on the concepts of price leadership and price discovery power please read Price Discovery and Common Factor Models article in Journal of Financial Markets, Feb 2002 by Richard T.Baillie, G. Geoffrey Booth and Yiuman Tse

[Figure 6 – Price leadership and discovery of underlying stock basket]



      
    
    Price Leadership


Singapore SSFs to empower price discovery

Earlier in Figure 3 of this article, we provided an estimate of the costs to an index arbitrageur. The largest cost component is the crossing of the bid-offer spread in the underlying stock basket. We now show the individual component stock contributors to the stock basket bid-offer spread cost, with the top 3 contributors being Singtel (16%), Genting (10%), and OCBC (7%).

 

[Figure 7: Bid-Offer Spread contributors into overall SiMSCI basket Bid-Offer Spread]



      
    
    SSF


In launching the Singapore SSFs on these principle components of the MSCI Singapore Free Index, market participants will be able to trade with a different market microstructure (narrower tick sizes), with the potential to reduce the bid-offer spread cost of executing index arbitrage strategies. This is naturally predicated on a certain base level of liquidity in the Singapore SSFs that will develop in time with the entrance of more international participants from the derivatives space.

Subject to regulatory approval, SGX plans to list Singapore SSFs to enhance the interaction between its securities and derivatives markets and thereby providing efficiency and price discovery for market participants. 



Heightened volatility fueled index arbitrage activity in Singapore stock market

United States

MSCI Inc. provides investment decision support tools to investment institutions worldwide. The Company produces indices and risk and return portfolio analytics for use in managing investment portfolios.

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MSCI Inc (MSCI US)

Heightened volatility fueled index arbitrage activity in Singapore stock market

Index arbitraging activities between SGX MSCI Singapore (SiMSCI) futures and SGX cash markets at a multi-year high of almost S$500...

Singapore Exchange Ltd (SGX)

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