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In this interview, Amy Borgquist from Goldman Sachs explains how dividend uncertainty affected the equity index futures roll and how TRFs can be an alternative to price index futures.
How does the current crisis impact the pricing of equity index futures?
Equity index futures trade at a basis to their underlying benchmark index, due in part to the implied financing cost priced by dealers, and the market expectations surrounding the dividend stream of the underlying index constituents up until contract expiration. Before the most recent (Mar-Jun20) futures ‘roll’ (that is, the period leading into contract expiration in which holders of futures open interest (‘OI’) typically close out their position, while entering into a longer dated contract on the same asset at the same time through a ‘calendar spread’) the assumptions for near-dated dividends have generally been stable, not least due to the tendency of companies to announce their upcoming dividends ahead of this roll period. As a result, this enhanced transparency surrounding realizable dividend amounts has allowed dealers to price the dividend risk embedded within the calendar spread basis at reduced cost. The timing of the March/June 2020 roll coincided with unprecedented measures taken by companies to withdraw their previous commitments to dividend distributions, in turn casting in doubt any former assumptions surrounding realizable dividend streams, and often with little to no clarity on revised guidance from companies given until well after contract expiry. Similarly, adding to this volatility was a rapid change in positioning (supply/demand dynamics for futures from end clients) and greater uncertainty surrounding the marginal financing cost for dealers to charge. As a result, the calendar spread basis traded in a range up to 90x that observed in the Sep/Dec 2019 roll (1.85% vs 0.02%).
You suggested that TRFs can be an alternative to price index futures. Could you please explain?
While clients with an explicit dividend view can surely play through the roll, we expect that many longer-term holders don’t need to expose themselves to this additional risk premia. For these clients, we would suggest looking at the TRF product, which separates the dividend component into a stream for the life of the contract, similar to a Total Return Swaps on Gross Total Return Indices. In more detail, a client going long will receive the price performance of the EURO STOXX 50® plus 100% of dividends, paid upon ex-date, and will pay EONIA plus a quoted spread (N.B. benchmark in future to be transitioned in the future to €STR). Due to the Total Return nature of these products, there is less pricing sensitivity to dividends compared to price return futures.
How can investors trade TRFs?
Clients can trade TRFs on screen. Still, the liquidity is not quite what we see on the price return contract. So, until this changes, clients can block trade versus dealers in meaningful size or can still use the price return future for any intraday delta needs, converting to the TRF at market-on-close. This can be done by quoting a package of two legs: Firstly, a basis to sell the Price Return future and secondly, a spread to EONIA to buy the TRF. Clients can even quote this package before the trading sessions (with max size specifications) and trade the Price Return future on-screen during the day. Then, post-close, finalize a trade and exchange Price Return futures vs. a Total Return future.
More generally, how do you see the opportunities for investors to trade TRF?
The current open interest in TRFs exists across expiries (the December 2024 maturity has an open interest of more than €4.3bn. That is unlike Price Return futures, where the vast majority of open interest is concentrated in the ‘front month’ contract, typically a three-month maturity. Many clients are already active in the TRF and have express views on the term structure (the variations in spread across maturities). For example, clients could sell longer-dated contracts versus buying a shorter-dated expiry. The marginal (but significant) opportunity looking forward is for those currently using either OTC Swaps or price return futures. We expect a migration to occur here in the coming months and years, particularly as certain clients face increasing margin requirements on their OTC positions.
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