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Imperial College London Business School Trading Strategies in Futures Markets James Grant Submitted in partial fulfillment of the requirements for the degree of Doctor of Philosophy of Imperial College London Abstract The purpose of this thesis is to investigate trading strategies based on futures contracts. The first chapter demonstrates and analyzes the exceptional performance of both carry and momentum strategies in future markets across asset classes (commodities, bonds, equities, and currencies). In- dividual carry and momentum returns have low correlation, generating a significant diversification benefit in the combined portfolio and a Sharpe ratio of 1.4. Individually and combined, carry and momentum strategies have significant returns not explained by the CAPM or risk factor models. However, carry returns disappear after adjusting for lagged macroeconomic variables, suggesting performance is related to business cycle risk. Expected momentum returns are only weakly related to macroeconomic variables, but co-vary significantly with hedge fund capital flow - indicating returns are related to limits to arbitrage constraints of hedge funds. The second chapter establishes the economic significance of carry and momentum trading sig- nals. We use a model incorporating a time varying investment opportunity set into a parametric portfolio framework and derive optimal portfolio parameters. Without any ex-ante imposed rela- tion, in-sample portfolio parameters are found to be consistent with the results of the first chapter. Furthermore, out-of-sample returns are found to be highly significant, robust to transaction costs and not compensation for traditional risk exposure, time-varying risk due to macroeconomic cy- cles, or funding liquidity. Out-of-sample returns are significantly related to pro-cyclical hedge fund capital flows, suggesting expected returns decrease with speculative capital. The third chapter applies our parametric portfolio framework to assess the economic signif- icance of predictors important in commodity markets since 2001. The studied predictors are widened to include hedging pressure and three market wide predictors found in the literature to forecast returns. In contrast to our results for the whole futures market, we find little evidence for economically significant commodity strategy returns for either individual or combined predictors. 1 Contents Abstract 1 Acknowledgments 9 Introduction 11 1 The Returns to Carry and Momentum Strategies 18 I Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 II Returns, Leverage and Trading Strategies . . . . . . . . . . . . . . . . . . . . . . . . 22 A Data Set and Sample Contracts . . . . . . . . . . . . . . . . . . . . . . . . . 22 B Excess Futures Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 C Leverage Factor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 D Trading signals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24 E Trading Rules and Portfolio Construction . . . . . . . . . . . . . . . . . . . 25 F Market, Macroeconomic and Hedge Fund Data Sources . . . . . . . . . . . . 27 III Characterizing Carry and Momentum Returns . . . . . . . . . . . . . . . . . . . . . 28 A Return Premia of Global Strategies . . . . . . . . . . . . . . . . . . . . . . . 28 B Return Premia within Asset Classes . . . . . . . . . . . . . . . . . . . . . . . 32 C Comovement Structure Globally and within Asset Classes . . . . . . . . . . 34 IV Understanding the Return Premia to Carry and Momentum . . . . . . . . . . . . . 35 A Risk Factor Models . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 B Time Varying Expected Returns and Business Cycles . . . . . . . . . . . . . 37 C Hedge Funds and Limits to Arbitrage . . . . . . . . . . . . . . . . . . . . . . 40 V What Can We Learn About Momentum by Observing Carry? . . . . . . . . . . . . 43 A Time Trend . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 B Recessions and Hedge Fund Liquidity . . . . . . . . . . . . . . . . . . . . . . 44 VI Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 VII Appendix: Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 VIII Appendix: Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 IX Appendix A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 2 Optimal futures portfolios and hedge fund capital 72 I Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 II Portfolio Construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 76 A Optimal Futures Portfolios with Predictable Returns . . . . . . . . . . . . . 76 B Portfolio Estimation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 78 C Construction of Tradable Futures Return Series . . . . . . . . . . . . . . . . 79 2 D Transaction Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 III Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 A Price Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 B Macroeconomic and Liquidity Data . . . . . . . . . . . . . . . . . . . . . . . 81 C Hedge Fund Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 IV Characterising Optimal Futures Portfolios . . . . . . . . . . . . . . . . . . . . . . . 82 A Carry and Momentum Portfolio Returns Across Asset Classes . . . . . . . . 82 B Effects of Changing Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . 86 C Diversified Investor with Optimal Futures Portfolio . . . . . . . . . . . . . . 87 V Business Cycles, Limits to Arbitrage and Hedge Fund Capital . . . . . . . . . . . . 89 A Optimal Futures Returns with Transaction Costs . . . . . . . . . . . . . . . 89 B Risk Factor Exposure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 C Macroeconomic Influences and Funding Liquidity . . . . . . . . . . . . . . . 91 D Hedge Fund Activity and Capital Flows . . . . . . . . . . . . . . . . . . . . 94 VI Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 VII Appendix: Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 VIII Appendix: Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 107 IX Appendix A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 A Statistical Inference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 112 3 Assessing the Economic Significance of Commodity Futures Price Predictors 114 I Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 II Methodology . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 117 A Parametrization of portfolio weights . . . . . . . . . . . . . . . . . . . . . . . 117 B Out-of-sample parametric portfolios . . . . . . . . . . . . . . . . . . . . . . . 119 C Performance Evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 III Data Description . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 A Futures Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 B Commodity Characteristics . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 C Macroeconomic Characteristics . . . . . . . . . . . . . . . . . . . . . . . . . 125 IV Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126 A In-sample optimal portfolio performance . . . . . . . . . . . . . . . . . . . . 126 B Out-of-sample optimal portfolio performance . . . . . . . . . . . . . . . . . . 128 V Robustness . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 A Sub-sample Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131 B Varying Risk Aversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 133 C Strategy performance across commodity classes . . . . . . . . . . . . . . . . 133 VI Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134 VII Appendix: Tables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136 VIII Appendix: Figures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 145 4 Conclusions 147 3
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