A nice rate if you can get it

A Dutch book is every gambler's dream - a set of odds and bets that guarantees a profit.

That lucrative position is usually reserved for a bookmaker or the casino that takes a punter's bets. But the phrase has been borrowed by a new hedge fund - one that aims to make money, come what may, from the interest rate decisions of central banks around the world. 字串4

"It's heartbreakingly easy," says Stan Jonas, a pioneer of interest rate derivatives markets who until recently traded the products at Fimat, the brokerage owned by Soci㩴㩠G㩮㩲ale.

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For anyone familiar with the idea of efficient markets, that sounds improbable. Especially since Mr Jonas invests in markets such as those for Eurodollar and Fed funds futures - two of the most liquid derivatives markets in the world, both of which track US interest rates.

Nor does Mr Jonas try to hide the strategy his DutchBook fund will use. He simply seeks out a series of positions covering every possible path of interest rates, so that he makes money whatever happens.

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The strategy depends on a number of features unique to interest rate markets. Take the US, for example. Eurodollar and Fed funds futures allow investors to hedge against, or take views on, what the Federal Reserve will do with short-term interest rates. 字串9

The dates of the US central bank's rate-setting meetings are known in advance. Commentators often say that futures are implying a certain likelihood that rates will go up or down at the next meeting. 字串3

Last week, for example, the implied probability of the Fed raising rates by another quarter of a percentage point tomorrow, August 8, was hovering above 30 per cent. But that makes no sense once the day arrives, notes Robert Kessler, the other partner in the DutchBook hedge fund, which is being marketed directly to investors. 字串9

"Probabilities expressed in Fed funds futures must converge to certainty as decisions are announced," says Mr Kessler who, as chief executive of the Kessler Companies, manages government bond portfolios for institutions and wealthy individuals.

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In other words, the "correct" probability of a rate rise will turn out to be 100 per cent or zero, with a couple of highly unlikely additional possibilities - a bigger rate hike, or a cut. 字串7

Central banks in the eurozone, the UK and elsewhere also meet to set interest rates on pre-arranged dates. This repeating pattern in which one of a limited number of defined outcomes must occur on a specific date is almost unique to these markets, and helps Mr Jonas. "It's metaphysical convergence," he says. 字串3

The increasing transparency of central banks' decision-making processes - sometimes influenced by financial markets as well as vice versa - also encourages investors to trade on their expectations. That has helped ensure another necessary condition for a successful Dutch book strategy - someone else has to bet first.

Also helping the strategy - notably in the US markets - is that, according to Mr Jonas, "every security is perfectly priced."

That is, based on the probabilities for interest rate moves implied by futures markets, the theoretical prices of every security - including interest rate futures and Treasury bonds - match the market prices to within a whisker. 字串5

This stems partly from the huge liquidity in these markets, which quickly eliminates obvious price discrepancies. But that again raises a nagging question - how can a Dutch book strategy work in such apparently efficient markets? 字串2

Part of the answer is that few people know as much about interest rate futures as Mr Jonas. He was involved in the nascent futures market in the 1970s and joined Fimat in 1991. 字串4

But there is a more tangible inefficiency in these markets. Many people use them to hedge other positions - portfolios of corporate bonds, for example, which lose value as interest rates rise unless they are hedged. That creates an asymmetry for Mr Jonas to exploit. 字串6

"Downside risk is much more important to people than upside risk," he says. "If I'm a huge hedge fund and I don't screw up, I'm going to carry on getting money [from investors]." 字串7

For instance, there were market whispers before the Fed meeting at the end of June that rates might go up a half point, even though almost everybody expected either a quarter-point rise (the eventual decision) or a pause. Somebody, says Mr Jonas, paid over the odds to protect against that outcome. 字串4

All this means that as Mr Jonas plots the possible course of Fed moves, looking as many as three meetings ahead, the implied probabilities of every possible outcome added together almost never come to 100 per cent. That in turn means that a Dutch book can almost always be constructed.

He describes a series of trades, back in May, that encompassed the seven feasible paths for interest rates over the subsequent three Fed meetings. With the parameters for each trade carefully selected, the result in six of the seven scenarios was a pay out about twice as large as the total cost of all three trades - potentially, a 100 per cent return in about three months. 字串4

The exception was the situation where the Fed paused in June, then cut rates in August. To complete the Dutch book strategy Mr Jonas would have spent a little more to buy an instrument that paid off in the event of that one improbable outcome.

In reality the returns are a bit lower. First there are transaction costs, and second Mr Jonas plans to take reduced but quicker profits as the market moves in favour of each instrument ahead of decision dates. 字串5

But he says the markets almost always present a virtually riskless profit opportunity. 字串3

"I am more and more convinced the trades will remain," he says, partly because as long as bond investors continue to hedge their portfolios, there will be imbalances in the market. 字串6

The DutchBook fund offers two different strategies. One is a leveraged fund that uses all Mr Jonas' trades, aiming to make money whatever central banks decide.

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The other uses only some of the Dutch book trades and is intended to hedge a portfolio of Treasury bonds. Those bonds rise in value when interest rates fall, but suffer when rates head higher. 字串4

The hedging strategy is also designed to ensure a win-win result, at a cost of no more than the coupon on a two-year Treasury. "In the worst case," Mr Jonas says, "you're self-insured." 字串7

Of course, if every set of trades is profitable, even that money is not at risk unless something very odd happens - "there's no Fed" is one of Mr Jonas' examples. But he's not one to tempt providence by being greedy beyond that "self-insurance". 字串7

"God is cruel," he says. "You never want to take more than that."