Growing trading volumes (see Charts 1 and 2) and the increasing number of contracts on offer are giving more confidence to users who have kept “a wait and see” attitude in the past three years. In 2003 trading volume increased by 61 per cent to 6.35m contracts and the addition of further contracts brought the total of companies on which USFs are listed to 143. During 2004 volumes have been so far positive, with a 117 and 207 per cent year on year increase in January and February respectively. The contracts now cover all the components of the FTSEurofirst 80 Index and the main European local benchmarks.
Key advantages
Universal stock futures were designed to provide flexibility.
However, their value proposition based on low cost, simplicity and
efficiency may be of interest to private wealth managers who do not
necessarily have access to an extensive global execution network or to
stock borrowing and lending facilities in order to short a single stock.
With
the exception of restrictions on the use of derivatives in private
portfolios imposed by specific mandates or regulators, the main reason
why private wealth managers have not been systematically using USFs is
probably due to unfamiliarity with the product.
Universal stock
futures are relatively simple instruments. However, as it often happens
with simple tools, they lend themselves to rather sophisticated uses,
and they involve a rather steep learning curve for both client and
manager.
In the examples below we try to explain how these
instruments can be easily used in very simple situations to achieve a
variety of objectives.
Examples
Universal stock futures are a suitable tool to hedge specific stocks
without changing the make-up of the underlying portfolio or being
forced to crystallise a loss. A very simple way to achieve this is to
sell short a USF against the existing single stock position in the
portfolio to “neutralise” the downside.
Let’s take a portfolio
benchmarked to the FTSEurofirst 80 Index that contains a position of
500 shares in Volkswagen established when the stock was at €45.75 in
September 2003. On 5 January 2004 the stock is trading at €44.34. The
stock outlook is negative in the short term but the portfolio manager
doesn’t want to sell it at the current price as he would materialise a
loss. He decides to sell short five contracts (one contract = 100
shares) of Volkswagen in the corresponding March USF at €44.43 in order
to neutralise any further potential downside in the stock.
The
prediction was correct and Volkswagen shares did indeed decline and on
19 February were trading in the cash market at €39.64, posting a loss
of 10.59 per cent over the period.
However, the loss was offset by
the gains made in the future position as the Volkswagen March USF has
also declined and is now trading at €39.70. The calculation is as
follows.
Loss on long stock position
- €44.34 – €39.64 = €4.7 x 500 = –€2350
Gain on short USF position
- €44.43 – €39.73 = €4.70 x 5 x 100 = €2350
In addition, to illustrate how USFs can be used to hedge an
individual stock position, this example also highlights the
relationship between the price of the stock and the corresponding
future.
A trading strategy that is gaining more popularity as a way
to generate alpha in equity portfolios is the relative value trades
between single stocks and their benchmark index.
This can be
achieved by combining USF positions with an equity index futures
position. If an individual stock is expected to outperform the market,
the strategy would be to buy futures on the stock and sell futures on
the market index. Futures are normally traded with equivalent
underlying notional value.
As an example, take an investor who
expects MMO2 plc shares to outperform the FTSE 100 Index over a period
of one month. Market prices are as follows:
2 February 2004
- MMO2 plc share: Ł83.75
- MMO2 plc USF March 2004: Ł84.50
- FTSE 100 Index*: 4388.80
- FTSE 100 Index Future March 2004: 4365.5**
(* The FTSE 100 Index is not quoted as a market – there are no bid or offer prices; ** the FTSE 100 Index future price is below the index cash level because of dividends) - The investor buys MMO2 USFs at Ł84.50 and sells FTSE 100 Index futures at 4365.5.
- The trade is for approximately Ł100,000, therefore the number of contracts traded is Ł100,000/(0.8375 x 1000) = 119 MMO2 futures and Ł100,000/(4388.80 x 10) = 2 FTSE 100 Index futures.
On 1 March 2004 the markets are as follows:
- MMO2 plc share: Ł105.82
- MMO2 plc USF March 2004: Ł106.00
- FTSE 100 Index: 4522.40
FTSE 100 Index Future March 2004: 4502.0
- MMO2 shares are up 26.35 per cent whilst the index is up only 3.04 per cent. The gain on MMO2 USFs is (1.06 – 0.8450) x 1000 x 119 = Ł25,585, whilst the loss on the Index futures position is (4365.5 – 4502.0) x 10 x 2 = Ł2730, leaving a net profit of Ł22,855.
Preferences
Private investors have preferences for the form in which investment
returns are accrued – ie a preference for either income or capital
gain. With conventional equity investment, this preference will lead
the investor to focus on high yield or low yield shares. Universal
stock futures can allow the investor to shift the balance between
income and capital gain within a portfolio whilst widening the range of
equities which the investor can consider using.
Futures contracts do
not pay dividends. An investment in futures can be used as an
alternative to investing in high yielding shares. Holding an equivalent
cash balance will ensure that the overall return will be the same –
capital gains will form a greater proportion of the total. A cash
deposit is maintained to ensure that the futures position and the
potential stock position are equivalent, ie additional gearing is not
introduced into investment, which will affect the return on capital.
Income in the form of interest will come from the cash deposit.
Reducing the amount of cash on deposit will reduce the interest income,
but will also increase the gearing of the strategy to movements in the
share price.
The same structure described above can be used to
increase portfolio income. As an alternative to buying shares which pay
no dividends, depositing cash and buying futures contracts will result
in an interest income being generated, and a lower capital gain. Total
return on this strategy will be the same a holding the shares – the
futures ensure that the exposure to share price movements is maintained.
In
essence, USFs are derivatives instruments that are simple to explain
and simple to understand. They can be used in a wide range of
situations, adding more sophistication to the management approach
without necessarily introducing more complexity in portfolios.
What makes USFs so useful
Some specific aspects are worth highlighting:
- They are cash settled – they do not imply physical delivery of the underlying
- They can take short positions, allowing managers to take advantage of both sides of the market – this makes them an ideal tool for directional trading
- They can be used to achieve tax savings – for instance being cash settled, UK stocks don’t attract stamp duty
- They can be used for dividend enhancement and dividend tax credit arbitrage
- The tax margining system makes them suitable for cash management in portfolios
- They can be employed by portfolio managers looking for a convenient way to generate alpha
- They allow risk management and hedging of individual portfolio components without disturbing the make-up of the portfolio or being forced to crystallise losses.
Contract specifications
- Currency: local currency of the underlying
- Unit of trading: contracts based on shares of Denmark, Finland, France, Germany, the Netherlands, Norway, Spain Sweden and Switzerland – 100 shares. Contracts based on shares of Italy and the UK – 1000 shares. Contracts based on shares of US – 100 shares
- Delivery months: nearest two of March, June, September and December, plus nearest two serial months such that the nearest three calendar months are always available for trading.
Max Butti, product manager, universal stock futures, Euronext.liffe
