Rational Pricing and Single Stock Futures (SSF)

Rational Pricing and Single Stock Futures (SSF)

Investing in stocks on more favorable financing terms.


Stock prices and their related SSF are closely linked.

The simple fact is that all capital markets are linked together so as to provide investors with an identical risk-adjusted rate of return for any given time horizon. This is a corollary to the law of one price, the basis for arbitrage. Whether we are buying stocks, bonds or simply providing a loan, we expect to make a return relative to the risk-free (or Treasury bill) rate of return. Restated, all investments are spread trades: You are selling cash—borrowing from yourself whether you realize it or not—in order to buy an asset.

If stock investors are borrowing from themselves, they should do everything possible to lower their financing costs. The best way to do that is to put single-stock futures (SSFs) back on their plates.

SSFs are contracts to buy or sell 100 shares of an underlying stock or 1,000 shares of many exchange-traded funds. Although an SSF contract can be offset any time prior to the contract’s expiration, normally the third Friday of the contract month, a contract held through expiration converts into either ownership of the stock for a long position or delivery of the stock for a short position.

If you are simply an investor looking to maximize the return on your capital, the first thing you want to do is get comfortable with the whole process: No one trades what they do not understand, or alternatively, what they think they do not understand. How many stock traders can tell you the interest-rate opportunity costs associated with their investments? Most of us do not know because we were never told we should care.
You should; it is real money and adds up quickly.

INTEREST RATES: LONG SIDE

Once you make the little mental leap to thinking of stock purchases and sales in terms of
interest rates, as well as in terms of price, you will find a surprising number o transactions
involved.
On the stock purchase side, interest-rate items include:

  1. 1. Margin loan charges, if applicable. If you buy shares using the 50 percent margin allowed under Regulation T, you will be paying an interest rate called a broker loan on the amount borrowed. A broker loan is typically one of the highest short-term interest rates.
  2. 2. Foregone interest earned. This is the opportunity cost involved in tying up money in the stock instead of investing it in a short-term interest rate instrument, minus the reinvestment income on the dividend received, if applicable over the SSFs holding period.

Let’s say you want to buy 2000 shares of a $50 stock. You will use $50,000 (taking it out of savings earning 1/10 of a percent) of your own money and borrow $50,000 from your broker (assuming you can borrow at 5%). Here is what your costs will be 30,60 ,90 and 180 days out in time:

Borrow Yourself Broker
100000 0.001 0.05
50 2500 2550
Interest
Time 30 days 60 days 90 days 180
Daily rate 7.08 7.08 7.08 7.08
Term rate 212.5 425 637.5 1275
per/share 0.11 0.21 0.32 0.64
Net price 50.11 50.21 50.32 50.64

Now if you could substitute a 1% borrow rate which is still above the average implied rate currently built into SSF, the numbers change dramatically:

Time 30 days 60 days 90 days 180
Daily rate 2.78 2.78 2.78 2.78
Term rate 83.33 166.67 250.00 500.00
per/share 0.04 0.08 0.13 0.25
Net price 50.04 50.08 50.13 50.25

Why would you pay more for the identical risk position?


Irrational Pricing Opportunities

As can be seen from the above discussion as long as we have a positive interest rate and positive time environment (and no dividends) the SSF should always trade at a premium to the underlying stock. There are anomalies in the pricing that occur because of pressures that are not apparent due to Securities Lending and Borrowing activity. When a trader wants to sell a stock short he needs to borrow it from someone else. This borrow is not free and the trader must pay a fee to the lender. Think of this fee as an interest rate that is paid and thus acts negatively on the price of the SSF. There are some stocks that have a 20% annualized borrow fee which when we plug into the equation makes the SSF numbers drop below the stock price:

Time 30 days 60 days 90 days 180
Daily rate -26.39 -26.39 -26.39 -26.39
Term rate -791.67 -1583.33 -2375.00 -4750.00
per/share -0.40 -0.79 -1.19 -2.38
Net price 49.60 49.21 48.81 47.63

For customers who are looking to purchase a stock to hold as an investment it would behoove them to look to the SSF markets first where they may be able to establish the position cheaper.

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