Prince-

Awesome post and valid arb idea, but several material errors. I’ll just point out the most egregious:

>>If this happens the security terminates, and Macroshares pays out the NAV at the close of the third day (approximately ($120 – (Barrel of Oil))/3).<<

Not exactly. Oil closing above $111 is the triggering event that terminates the trust. But then the shares continue to trade until the end of the calendar quarter. The holder of UCR gets the above formula based on the close on the last trading day of the quarter (not the third trading day of the trigger event, as you state).

This wouldn’t be much of a concern if the trigger event occurs in the waning days of the quarter (such as the next two weeks). But what if the trigger is pulled, say, in early April? Then the arb is biting his/her nails for nearly a full three months. Your dudeliness, anything, and I mean anything, can happen in three months, in a world where the Dow rises 418 points in one day, after falling 500+ in three. Oil could double or halve in that time.

All of this implies that should you get an early-quarter trigger, don’t look for the discount on UCR, or the premium on DCR, to close oh so quickly. The respective discount and premium reflect uncertainty about the eventual payoff. Thus, much of the “inefficiency” is rational.

I remain your loyal subject,

j’adoube

J’adoube, your comment is correct. The investor would only be exposed to fluctuations in the value of the Treasurys that make up the NAVs of the two funds. You are correct that the shares would continue to trade and would not pay out the NAV to investors until the last trading day that quarter. The eariler statement was a mistake by The Prince.

I do disagree with your comment about the investor biting his or her nails for three months after termination. Once the fund terminates the NAV will only change based on the fluctuations of the value of the Treasurys which the two funds hold. Remember that both of these funds just trade cash back and forth based on the published price of oil (they are derivatives in the purest sense of the term). So you are right that the price of these securities could still be off the NAV after the funds terminate when oil reaches $111 for three days but the NAV will remain essentially fixed.

I agree that some of the “inefficiency” here is rational since many investors are buying DCR to express the view that oil is going down. They may be doing this because they do not want to short UCR, OIL, or USO.

j’adoube sent this to the Prince a few hours ago:

Prince, I love you like a brother, but you are living in a paradise of your own making.

>>Once the fund terminates the NAV will only change based on the fluctuations of the value of the Treasurys which the two funds hold. <<

No. Not according to the folks at Macroshares. And I’ve gone over this with them chapter-and-verse.

The NAV of the two respective funds continues to fluctuate based on the price of crude, even after the trigger is hit (3 days above $111). I did receive a bit more precision as to the date from which the final price is taken. It is the day before the ex-date. This quarter, the record date is 3/31, the ex-date is 3/27, and so it is the closing price of crude on 3/26 that decides what you get for UCR and DCR.

Also, another little kink: You should use the next month now, not the current month, as your benchmark. Starting 3/17 (fewer than three trading days from now), the next month will be the benchmark for pricing the units. That month is trading at $107.45, vs a recent $108.65 (after hours). So we’re still nearly $4 away from a trigger.

I bought DCR this morning at 31 and hedged it with a short in OIL at 64.30.

5:2 ratio. (slightly underhedged)

(One omission in your presentation is that should oil crater, you should experience some convexity in a long UCR /short OIL/USO hedge, so that you will not need a 1:1 short on the downside. On the contrary, for every successive dollar that crude falls, UCR is likely to fall progressively less, perhaps going to a premium if crude falls enough, as the bounce-betters charge in).

So, pray tell, if you think this is such a juicy trade, why do you not have a position in it?

j’adoube

The Prince:

I am not in the trade because I think that oil is going down and I don’t see a catalyst for the spread to close if oil falls. I was pointing the trade out because I thought it was interesting and all investors should carefully evaluate the trades on this site.

You clearly know a lot more than I know about UCR and DCR. You are right about the convexity if oil does crater meaning that I need to adjust the short position. I believe you mean you bought UCR this morning not DCR and hedged it by shorting OIL. Using the next month for oil is correct as you suggest for the benchmark.

When it comes to the details on the ex-date and record date you clearly know more about these securities than me so I am going to have to defer to you.

-The Prince

J’adoube-

I agree that it switches to May futures on monday.

When you talked to Macroshares did you ask them what happens if during the time between the trigger and the ex-date oils goes above 120?

The entire reason for the trigger is so one side does not go bankrupt. If that happens would a DCR shareholder owe a UCR holder money?

I’ve done the trade, shorted DCR, longed UCR, and want to make sure about the fluctuating after the trigger. It would definitely change my opinion as expecting oil to stay above 111 for 1 1/2 weeks is more of a stretch than 3 days.

http://www.bloomberg.com/apps/news?pid=20602013&sid=aiJwKuOdOC4Y&refer=commodity_futures

J’adoube-

You are correct about the distribution dates. Your dates are exactly correct (distribution date, termination trigger, and the last pricing date) and the payments are correct. It took me about 2.5 hours in that prospectus to figure this all out by the way, which is written in lawyer-speak.

You are also right about the 1-month setback. Today the May futures are at 108.50 and the April’s are at 109.89. Our third day for the trigger now is Monday, and that reflects the May futures. If we don’t hit a trigger in the next week and a half, then we will have to deal with the fluctuation in oil prices for three months to get our payout.

My only real concern, again, is that oil shoots above $120. Then your hedge goes down in value while your long UCR/short DCR stays the same. If we pass March 24th without the price of $111, you may want to consider a 3 month call option at $100 for USO (or $125/barrel oil). If oil goes above $120 I assume the fund will pay out the full amount of the distribution to UCR on the distribution date, and now the DCR security, strangely, becomes a put on oil at $120 and the UCR is writing a put at $120. Also, these should be priced as European options (not American ones). This could lead to an additional arbitrage opportunity. Very interesting.

As far as the convexity goes, that will actually help the trade (especially if UCR goes to a PREMIUM and DCR a discount then the trade is over). The one part I don’t understand, and this is to j’adoube: Why should we take some of the hedge off? Why not be fully hedged with a short on USO/OIL?

Clearly, if we pass March 24th without a trigger we may want to rethink the trade. Indeed, the days preceding March 24th will be quite volatile, especially if we hit a trigger and the oil price hovers around $111. This should be fun.

FYI, I put the trade on with a full hedge, that is 2.4 shares long UCR to 1 share short USO, which has no exposure to the price of oil.

Best,

Nostradamus

Prince, Nostradamus, et al,

First, yes, of course, I meant UCR, not DCR. Between this arb and the market volatility, it’s been easy to confuse down and up lately. A tad dangerous as well.

First: My understanding is that for any terminal price above $120, UCR redemption value = $40, and DCR redemption value = $0. If oil goes to $200 by the day before ex-date, UCR holders still get only $40, and DCR holders get $0.

Ok, now for Nostra’s message. All of what you said I agree with, and you’re causing me to rethink my slightly underhedged position IN THE SHORT-TERM. I think a fully hedged or even slightly overhedged position may be more appropriate UNTIL March 24. Then I would reduce back to a more neutral hedge, if the trigger has not been hit, because then you will have to wait for a whole quarter for the key price.

My (UCR/OIL, 5:2) hedge ratio gives me a zone of profitability, once the trigger is hit, of $57 per barrel to $144 per barrel, by my estimate, and that’s assuming that UCR trades at par down at the $57 area. We agree it may well be at a premium by then.

Your hedge ratio provides for less comfort should oil shoot up above $120, but more profit on a quick reversal. Seems reasonable to me.

Now, the timing is tricky here. If oil keeps dancing around $111 through next week, yes, a fully hedged position, or even an overhedged position, makes sense, because the odds that oil trades above $120 on March 26, with just a few days to go, is greatly lessened.

But if we don’t hit the trigger by March 24, then set the shot clock to three months again, and anything can happen in that time. Hence the need for a hedge that provides some room on the upside. Remember, what you call fully hedged is NOT fully hedged, it’s overhedged, because the return profile to UCR is assymetric — you get only a max of $40 for it at a price above $120/barrel, but on the downside, bombs away.

That’s why I prefer YOUR hedge ratio until Monday, and then MINE after Monday, if we’re unsuccessful.

Capische?

j’adoube

Excuse me:

Asymmetric, not assymetric.

Nostradamus said “FYI, I put the trade on with a full hedge, that is 2.4 shares long UCR to 1 share short USO, which has no exposure to the price of oil”.
Are you also short DCR?
There is substantial exposure should oil go up past the UCR limit at about 119 (unless you buy the calls on USO).

Out of the trade this morning, 4/15.

$4.65 profit on the long UCR
x5 (bt at 31, sld at 35.65)

$3.15 loss on the short OIL
x2 (shrt at 64.30, cvrd at 67.45)

33 days

Much of the juice has been squeezed from this orange.