Futures Beta Overview with Different Benchmarks

10월 13일

Beta Trading and Its Implementation with Futures

Understanding Beta

Beta is a measure of a security's volatility in relation to the overall market. It represents the sensitivity of the asset's returns to movements in the market, typically benchmarked against an index like the S&P 500. A beta of 1 indicates that the asset moves in line with the market, while a beta greater than 1 suggests higher volatility and potential risk, and a beta less than 1 indicates lower volatility.

The Beta Trading Strategy

Beta trading involves creating positions that exploit the discrepancies between the theoretical (or expected) beta of an asset and its actual market performance. The strategy often includes:

Long Positions on High Beta Assets: Investors might take long positions in assets with high beta when they expect market conditions to improve, as these assets have the potential to generate higher returns.

Short Positions on Low Beta Assets: Conversely, shorting low beta assets can be a strategy when the market is expected to decline, as these assets tend to perform better in down markets compared to high beta assets.

Betting Against (Bad) Beta

The paper "Betting Against Beta" by Frazzini and Pedersen (2014) provides insights into a trading strategy that involves betting against high beta stocks in favor of low beta stocks. The authors argue that high beta stocks do not provide the expected return premium over time, and that low beta stocks can yield higher risk-adjusted returns.

Key Points from the Paper:

Risk Premium: The authors assert that investors irrationally demand a higher risk premium for holding high beta stocks, leading to an overpricing of these assets. Conversely, low beta stocks are often undervalued.

Empirical Evidence: The paper presents empirical evidence showing that portfolios of low beta stocks outperform portfolios of high beta stocks over long periods. The performance difference is attributed to the irrational behavior of investors who overvalue riskier assets.

Market Conditions: The paper suggests that the underperformance of high beta stocks is particularly pronounced during market downturns, making low beta stocks a more attractive investment during volatile periods.

Implementation of the Strategy with Futures

Futures contracts can be used to implement the betting against beta strategy due to their ability to provide leveraged exposure to various asset classes. Here’s how the strategy can be executed using futures:

Identify High and Low Beta Futures: The first step involves identifying futures contracts that have high beta characteristics (more sensitive to market movements) and those with low beta characteristics (less sensitive). For example, commodity futures like crude oil or agricultural products might exhibit high beta due to their price volatility, while Treasury bond futures might show lower beta.

Construct a Portfolio: Investors can construct a portfolio that goes long on low beta futures and short on high beta futures. This can involve trading contracts on stock indices for high beta stocks and bonds for low beta exposures.

Leverage and Risk Management: Futures allow for leverage, which means that a small movement in the underlying asset can lead to significant gains or losses. Proper risk management is essential, using stop-loss orders and position sizing to mitigate the inherent risks associated with leveraged trading.

Adjusting Positions: The positions may need to be adjusted based on market conditions and the ongoing performance of the futures contracts. Continuous monitoring and rebalancing of the portfolio are essential to maintain the desired risk profile.

Performance Evaluation: Finally, investors should regularly evaluate the performance of the portfolio to ensure it aligns with the expected outcomes of the betting against beta strategy. Metrics like the Sharpe ratio can be used to assess the risk-adjusted returns of the portfolio.

Conclusion

Beta trading, particularly the strategy of betting against high beta assets, presents a compelling approach to capitalizing on market inefficiencies. The research by Frazzini and Pedersen emphasizes the benefits of focusing on low beta assets, which can yield more favorable risk-adjusted returns over time. When implemented using futures, this strategy can provide a flexible and efficient means to execute trades while managing risks effectively.

References

Frazzini, A., & Pedersen, L. H. (2014). Betting against beta. Journal of Financial Economics, 111(1), 1-25.

Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. Journal of Finance, 47(2), 427-465.

Black, F. (1972). Capital Market Equilibrium with Restricted Borrowing. Journal of Business, 45(3), 444-454.

Ang, A., & Chen, J. (2010). Asymmetric volatility: Evidence from the stock and bond markets. Journal of Financial Economics, 99(1), 60-80.

By utilizing the insights from academic literature and implementing a disciplined trading strategy, investors can effectively navigate the complexities of beta trading in the futures market.