DOW swap impact to us hedgers

by Jay Pestrichelli on September 10th, 2013

This morning S&P DOW Jones Indices, LLC announced the Dow Jones index will be swapping out 3 stocks effective September 23rd. Entering will be Goldman Sachs (GS), Visa (V), and Nike (NKE). Exiting will be Hewlett Packard (HPQ), Bank of America (BAC) and Alcoa (AA). Changing two stocks out is relatively common, but not since 2004 have 3 stocks been changed in a single swoop.  
They stated that these changes "were prompted by the low stock price of the three companies slated for removal and the Index Committee's desire to diversify the sector and industry group representation of the index." I guess price does matter afterall.
Here’s a link to the Wall Street Journal’s article with some additional information. 
Or if you prefer, Click here to see the CNBC interviewwith David Blitzer, S&P 500 Index Committee Chariman. 
Two of the exiting stocks are ones that we’ve written about before. HPQ and BAC have been the subject of many blog posts for us at Buy and Hedge. What is interesting is that these were the best performers over the last 2 years in the DOW, but not good enough to keep them in the index.

In 2012 BAC had an index leading gain of 108% and so far in 2013 HPQ is up 57% as of yesterday’s close.   While we haven’t done the research ourselves, CNBC is reporting that historically the ones that leave the index perform better than the ones that enter.  Can someone say “Pairs Trade?”
As hedgers, we’re very interested what this does to the volatility of options for the index as we use it from time to time to create portfolio level protection. As of yesterday the DJX (the1/100 Dow Jones Industrial index) had an implied volatility of 14.4% and the DIA (the SPDR Dow Jones Industrial Average ETF) had an IV of 14.8%. By comparison, this is lower than the S&P 500 volatility of 15.8% or the NASDAQ 100 IV of 16.3%.
This means that the Dow Jones Index has been less volatile this year, and this swap out actually brings in stocks of more stability. The IV for the exiting stocks is as follows:
AA: 31.15             BAC: 29.29           HPQ: 26.81
And the IV for the newly added stocks:
​GS: 28.15%          NKE: 28.15%       V: 24.85%
A lower volatility would lead us to believe that the cost of hedging should be lower as well. However, this depends on how the weighting flushes out as the index uses a price weighted calculation. That means that these newly added stocks with their higher per share price could make a bigger impact than the low dollar exiting stocks. Remember that these 3 additions have a significantly higher volatility than the current index of 14.4%
To sum it up, with the higher stock prices having a greater effect on the index volatility and the historical data informing us that the newly stocks do worse than the exiting ones, we actually expect this to increase the cost of hedging with the DJX as the index volatility will most likely rise despite bringing in more stable companies. 

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