By Antoine Porcheret, equity derivatives strategist, Europe, at BNP Paribas.
Equity derivatives are about futures and options whose pricing requires a set of parameters specific to the underlying security, including volatility, dividends, and repo. The first two parameters are well known and have become asset classes in their own right.
Investors have been able to position directly on volatility and dividends via various instruments — volatility futures, variance swaps, or dividend futures. However, repo trading has remained confined to a handful of players at best, or completely discarded at worst. This in unjustified in our view, given that repo is key in derivative pricing and can be monetised to generate alpha.
Investors are mostly familiar with equity repo in the context of securities lending. For example, selling a stock without owning it requires borrowing the security and consequently paying a fee, the repo rate, to the lender. The higher the demand to borrow a security, the higher the repo rate.
We can extend this concept to index futures, the most liquid equity derivative instrument.
The cost of physically holding shares
Let’s assume that an investor buys a future expiring in three months on the Euro Stoxx 50 index, the leading blue-chip equity index for the eurozone. The investor’s counterparty will be left with a short futures position and will consequently cover this short by physically replicating the Euro Stoxx 50 by buying its components. Effectively the dealer has a short future, long physical shares position, and therefore will have the opportunity to lend these shares out to the market and receive extra income by receiving the repo rate from stock borrowers.
This potential extra income will be passed through to the initial investor upfront through a lower price for the futures contract. The higher the repo rate, the lower the dealer’s cost of physically holding the shares, the lower the futures price for the investor.
When pricing futures, dealers have to anticipate what extra income could be generated when carrying their physical shares. Futures prices thus include the market’s expectations for this potential extra income, so the cost of holding physical shares.
This is the implied equity repo rate, which can be seen as an indicator of the market’s appetite to own physical shares. By extension, because options, like futures, are synthetic instruments, they are also sensitive to changes in the implied repo rate. Any equity investor is therefore exposed to the implied repo whether they own the physical shares or derivatives and should therefore monitor it and seek opportunities.
Opportunities arise as the implied equity repo rate is not constant over time. It has its own term structure, similar to implied volatility or dividends, because different flows affect it at different maturities.
Short-term repo rates are impacted by the very appetite to own physical shares. Among other drivers, this appetite is related to:
· market moves — sharp market drops lead to sudden needs to sell physical shares
· financial regulation — which affects a bank’s capacity to carry equity inventories on its balance sheet
· the availability of physical shares — the Bank of Japan equity exchange-traded funds (ETFs) purchase programme removes equities from the market, for instance.
In terms of long-term implied repo rates, these are directly affected by the trading of forwards and options with long tenors. They include equity-linked structured products sold to retail and private banks, or hedging instruments used by insurance companies or asset managers to insure structural long positions against losses. These large volumes make up the bulk of the supply of long-term repo risk and thus distort implied repo levels, as they would for implied dividends and volatility.
As of today, the term structure of implied repo rates is downward sloping. That means the term structure of the opportunity cost of holding the shares is upward sloping. With the Euro Stoxx 50 for example, the higher the repo rate, the higher the extra income of lending out the physical shares, the lower the dealer’s cost of holding the shares. If the cost is negative, it means that the dealer can generate extra income by lending out the shares. Conversely, if it is positive, as it is at the time of writing, holding physical shares costs the dealer.
Total return futures: liquid exposure to implied equity repo
It is possible to generate alpha by capturing the differential between the holding costs on different tenors. This is done by trading a spread of total return futures (TRFs) with two different maturities. TRFs have been the most common and liquid instrument used to trade implied equity repo.
A TRF is above all a future, where the buyer receives the performance of the Euro Stoxx 50 index plus the dividends distributed on a daily basis — so a total return of the index — and pays the benchmark interest rate, Eonia.
With a TRF calendar spread, the directional positions of the two legs offset each other as the investor is long one TRF and short another. As a consequence, the pay-off of the strategy will be the differential of the holding cost between the two maturities. The investor will pay daily the cost on the TRF leg where they are long, and receive a higher cost on the TRF leg where they are short.
There is another way of generating alpha by trading repo. Assume that an institutional investor sells standard quarterly index futures to tactically hedge its long cash equity holdings. The short futures position changes according to market conditions and the investor’s view. However, large institutional fund managers display recurring residual short futures positions year after year. These futures require maintenance as they have to be rolled over every quarter, incurring execution and transaction costs, as well as rolling risks.
Indeed, as short-term repo rates move, there is an ongoing uncertainty over the level of the holding cost that will prevail when futures must be rolled over to the next quarter. Therefore, investors anticipating a residual futures position could replace them with TRFs of longer maturities; one year for example. In addition to saving the cost of rolling the position every quarter, investors could pocket the differential between three month and one year holding costs if this one is positive.
Equity repo rates are not just the price of going short a security though. They sit at the confluence of derivative pricing, market conditions, financial regulation, collateral management and transactions.
Equity repo deserves to be placed at the heart of alpha generation in the same way volatility and dividends are. With the introduction of specific listed instruments, investors now have the means to monitor and extract information about this parameter, as well as generate alpha by monetising the potential dislocations of the implied equity repo.