Isn’t another risk if the market tanks within the first few months, because you will have to pay the withdrawal penalty from the CD out of pocket before you have the interest accumulate? This risk seems proportionate to the benefit (given that we have more than one huge correction every 50 years, there is a > 2% chance that the market will have a huge correction in the first year).
You say that you are moderately confident that the risk did not include this case, so I’m likely missing something (or you need to do a moderate update).
Another thing I’m still curious about is who the buyers of these box spreads are (assuming the legs are sold as a combination and not separately) . The discussion says the arbitrage opportunity comes from the FDIC but the FDIC does not directly buy the spread; they allow the CD to exist, which the buyers should have access to. So do the buyers have access to options but not CDs, or are there other advantages that they have which I am missing?
the FDIC does not directly buy the spread; they allow the CD to exist, which the buyers should have access to
I’m not sure how important FDIC insurance is to the story here, but worth noting that it has a 250k per account limit. So I don’t think financial institutions would have access to an unlimited amount of it.
The risk is small, because for most CDs the withdrawal penalty is small. My credit union allows partial withdrawals and charges a fee of 6 months’ interest (about 0.625%) on the amount withdrawn, so if the market tanks 30% and you have to redeposit say 20% into the margin account, you have lost a negligible 0.125% and the box spread trick still comes out ahead for the year. 6 months’ interest is typical. It’s important to choose a bank or credit union that has reasonably lenient terms, though.
The risk is small, but so is the benefit. As a result this was not a trivial analysis for me. I doubt if it’s low risk to redeposit just 20% at a 30% market drop due to volatility (the recent intraday crash movements exceeded 10%, and you get a margin call at a 40% with the 250k/150k example). After mulling it over I think I agree that it is worth it anyways though.
Here’s some more examples that I ran over. A better person would figure out the probabilities and equations to integrate over to calculate the expected value.
Withdrawing 75% at 0 months should be the break even (you lose .625% * 37.5k = 700 to penalties, but you get back a bit more than that with interest of .625% * 112.5k * 3 years = 700).
If you don’t need to withdraw within the first 6 months, you are ahead. Let’s look at the 100 percentage withdrawal case first to keep it simple. So the actual break even is withdraw 100% at month 6, and any time before this you lose money. If this happens at day 0 you lose .625% * 150k, or .375% of your portfolio as the worst case scenario. So the interesting loss scenarios range from 75% immediately to 100% in 6 months.
I don’t have the probabilities of these events happening, but casually looking at it, it seems like they happen at a significantly lower probability than the equal or greater gains case. Though it should reduce your expected value by a small amount.
Isn’t another risk if the market tanks within the first few months, because you will have to pay the withdrawal penalty from the CD out of pocket before you have the interest accumulate? This risk seems proportionate to the benefit (given that we have more than one huge correction every 50 years, there is a > 2% chance that the market will have a huge correction in the first year).
You say that you are moderately confident that the risk did not include this case, so I’m likely missing something (or you need to do a moderate update).
Another thing I’m still curious about is who the buyers of these box spreads are (assuming the legs are sold as a combination and not separately) . The discussion says the arbitrage opportunity comes from the FDIC but the FDIC does not directly buy the spread; they allow the CD to exist, which the buyers should have access to. So do the buyers have access to options but not CDs, or are there other advantages that they have which I am missing?
I’m not sure how important FDIC insurance is to the story here, but worth noting that it has a 250k per account limit. So I don’t think financial institutions would have access to an unlimited amount of it.
The risk is small, because for most CDs the withdrawal penalty is small. My credit union allows partial withdrawals and charges a fee of 6 months’ interest (about 0.625%) on the amount withdrawn, so if the market tanks 30% and you have to redeposit say 20% into the margin account, you have lost a negligible 0.125% and the box spread trick still comes out ahead for the year. 6 months’ interest is typical. It’s important to choose a bank or credit union that has reasonably lenient terms, though.
The risk is small, but so is the benefit. As a result this was not a trivial analysis for me. I doubt if it’s low risk to redeposit just 20% at a 30% market drop due to volatility (the recent intraday crash movements exceeded 10%, and you get a margin call at a 40% with the 250k/150k example). After mulling it over I think I agree that it is worth it anyways though.
Here’s some more examples that I ran over. A better person would figure out the probabilities and equations to integrate over to calculate the expected value.
Withdrawing 75% at 0 months should be the break even (you lose .625% * 37.5k = 700 to penalties, but you get back a bit more than that with interest of .625% * 112.5k * 3 years = 700).
If you don’t need to withdraw within the first 6 months, you are ahead. Let’s look at the 100 percentage withdrawal case first to keep it simple. So the actual break even is withdraw 100% at month 6, and any time before this you lose money. If this happens at day 0 you lose .625% * 150k, or .375% of your portfolio as the worst case scenario. So the interesting loss scenarios range from 75% immediately to 100% in 6 months.
I don’t have the probabilities of these events happening, but casually looking at it, it seems like they happen at a significantly lower probability than the equal or greater gains case. Though it should reduce your expected value by a small amount.