NEEDHAM, Mass. (HedgeWorld.com)–Fixed-return options may fulfill some of the promises once optimistically attributed to single-stock futures, according to a recent research report from TowerGroup.
Senior analyst Matthew B. Bienfang began his report with the observation that the American Stock Exchange has proposed the listing of fixed-return options, products that already exist in over-the-counter transactions where they’re generally called binary or all-or-nothing options. The idea is that the buyer of a contract receives a payment of a certain amount if the stock price is above the strike price on the expiration date or nothing if it isn’t.
The key benefits that originally made single-stock futures (or “securities futures,” generally, including narrow-based indexes) seem attractive were, in Mr. Bienfang’s analysis, three: “The first is that they will allow investors to take positions in a more cost-effective manner [without margin lending or stock borrowing and their associated costs]. … The second characteristic is that the margin requirements set by the regulators are likely to make these products more capital efficient than trading in the underlying securities.” The third benefit is that single-stock futures may provide a favorable vehicle for overseas investors who want to put money into the capital markets in the United States, for reasons including tax exposure and currency risks.
Fixed-returns may share the first two of those benefits, although they don’t offer the same benefits for overseas investors that single-stock futures do.
On the other hand, fixed-return options have an important advantage over single-stock futures in that the systems required to support such a product exist already; institutions can apply existing binary models to the fixed-return option and the product is unequivocally equity, not an equity/futures hybrid. Fixed-return options are cash settled, too, so that although they lack the leverage of single-stock futures, they avoid any delivery risk.
With the benefit of hindsight directed at the period in which the legislative and regulatory groundwork for the listing of single-stock futures in the United States was laid (2000 to 2001), some of the enthusiasm seems exorbitant.
“When these things [single-stock futures] were rolled out,” Mr. Bienfang said in an interview, “there was a lot of hype about how they were going to be a retail product. That never happened, in part simply because the learning curve’s pretty steep.”
As a product for professionals and institutions, they continue to hold promise and there is some indication that they are gaining popularity. In the “costs of execution and putting on a trade there are advantages to going the futures route.” There is no up-tick rule and no stock loan costs to contend with. Additionally, rather than crafting a synthetic future using multiple options, the single-stock future takes care of this, Mr. Bienfang said. But this promise has been slow of fulfillment.
James Newsome, former chairman of the Commodity Futures Trading Commission, said recently that the reason for their disappointingly low trading volume is the lack of a risk-based portfolio-margining regime. Mr. Bienfang, who has been with TowerGroup for a year and a half, doesn’t disagree with that, but he regards it as “a component of the broader hurdle of combining these platforms and a lack of investor demand.” He said that if the consumers did demand it, the platform vendors would create the functionality.
Mr. Bienfang said that one can’t “write off the single-stock future” yet. As he pointed out in the research report, when exchange-traded funds were new, they too developed only in fits and starts. It took the exchange-traded fund five years to become a mainstream product. But he does think that the fixed-return option may stand a better chance of immediate acceptance than the single-stock future did, precisely because it is an unambiguously equity product.
Contact Bob Keane with questions or comments at: firstname.lastname@example.org.