13 Nov 2019

Eurex Exchange

Total Return Futures: practicalities of using this instrument to manage repo risks

Total Return Futures (TRF) contracts were introduced by Eurex Exchange in December 2016 to provide market participants with a new instrument for their use in managing repo risks on equity markets. Since their introduction, TRFs have gained significant traction and have taken over much of the flow that used to go to Total Return Swaps (TRS). In a recent DerivSource webinar, market participants and experts from Eurex Exchange, Citi, BFAM Partners Limited and the University of Kent discussed the rapid rise of TRFs, their inclusion in trading strategies, and the various practicalities surrounding their use. Watch related webinar recording now.

What are Total Return Futures?

Total Return Futures (TRFs) are growing in popularity as market participant look to this new instrument to manage repo risks on equity markets. The aim of the TRF was to replicate the payoff profile of the Total Return Swaps (TRS), but in an exchange-traded and centrally cleared format that would be understood by those traders. As a standard future, Eurex Exchange pays all of the total returns, and the gross dividends in terms of distributions.

The key for Eurex Exchange was to make the product standardized and fungible. In terms of the product itself, Eurex Exchange rebalances on a daily rather than a periodic basis. This allows them to use the overnight interest rate. Until recently, it was benchmarked against the Euro OverNight Index Average (EONIA). It is now benchmarked against the equivalent of EONIA, which in Europe is €STRplus 8.5 basis points. This allows firms to trade the spread as they would in a swap, and that spread can be positive or negative depending on the underlying inverse repo rate and other elements in the pricing.

“Eurex also uses this product, or the spread of those products, to calculate the price of the future in index points. This allows the product to be fungible and nettable in all of the ways that you would expect of a centrally cleared futures product,” said Stuart Heath, Executive Director, Equity and Index Product Design at Eurex.

How are TRFs being used in trading strategies today?

“A typical TRF trade would be a classic repo carry trade, where an investor buys a short-term TRF and sells a longer-term TRF. Everything cancels out, except that on the long end you would receive a higher spread,” said Antoine Porcheret, senior equity trading strategist at Citi. As time passes, you carry on the term structure, you roll down on the term structure, and carry a positive rate. That is the classic carry trade, which is used by hedge funds or risk premium asset managers. The point is to take advantage of this term structure in contango, upward sloping, to harvest a risk premium. That’s the historically popular trade, which was also used with TRS a few years ago.

A typical TRF trade would be a classic repo carry trade, where an investor buys a short-term TRF and sells a longer-term TRF. Everything cancels out, except that on the long end you would receive a higher spread,” said Antoine Porcheret, senior equity trading strategist at Citi.

Another trade, which is increasingly popular, is to optimize the classic US Euro STOXX 50® position using TRF. For example, some pension funds are long physical shares for a decent size. And from time to time they sell short futures to hedge this position. These short futures positions change as time passes. But the size is so big that year after year they always have a residual short futures position. These short futures positions, which can be 10,000 contracts, or 100,000 contracts, have to be maintained every quarter. Firms have to roll these futures, which incur transaction fees, but there is also a roll risk. They have no idea every quarter what equity financing rate they are going to receive.

With the term structure as it is now, firms might anticipate that a year out they will be short 10,000 contracts. Instead of selling quarterly futures, they could sell a one-year TRF. For one year they have nothing to do, nothing to roll, no transaction cost. On top of that, they will receive, per the term structure, a higher spread. They are able to optimize cost and improve the carry of their short futures positions. In the same spirit, if they want to go long the market, they would favour short-term futures instead of long-term TRF. 

Drivers and opportunities

“Opportunities exist because the TRF spread is not constant with time. TRFs quote out to 10 years, quarterly up to five years and then annually up to 10 years,” said Porcheret. Different transactions with different maturities create supply-demand imbalances on different maturities. As a result, TRF spreads have developed a proper term structure, he said.

Looking at the Euro STOXX 50® , in the very short term, the curve will be most impacted by securities lending transactions, equity financing, collateral upgrade, inventory optimization. With longer term maturities, firms are looking more at futures, short-term options, but there are some balance sheet constraints. The longer the maturity, the more trades are options and exotic options driven, especially at the very back end of the curve. The main driver of the long-term TRF spread is the structured product market, which is enormous on the Euro STOXX 50® , said Porcheret.

Initially, the product was mainly envisioned as a tool for sell-side firms, with structured products at the far end and with other determinants at the near end, to hedge the repo rate. While that was where the initial demand came from, TRFs are now becoming more prevalent as a regular futures product, according to Heath. More participants are joining, and it is now starting to be explored by end client business. So instead of being just a hedging tool for repo structured products, TRFs are becoming a more prevalent product for various strategies. In terms of global access, the listed format also allows US investors to trade this market as TRFs are CFTC approved.

Practicalities of using TRFs

However, TRFs remain an institutional product. “A TRF does not trade like a typical future – it is a representation of a TRS converted into the economics of futures by the exchange. It is a lookalike of a TRS, converted into a daily settling future,” said Manish Garg, portfolio manager, equity trading, BFAM Partners Limited in Hong Kong. Since it is an institutional product, market-makers make an indicative wide price. But the trading on TRFs is much tighter. Mark-to-market is also important. The bid offer could be easily two to three basis points, so this is not a product to trade in and trade out, Garg said. 

The TRF spread is like an interest rate, in the sense that there is a duration risk. The longer you go on the curve, the higher the duration and the more sensitive to any change in the spread it will be. Firms have to be careful about trying to anticipate and analyse how this curve could evolve in the future. However, when putting on a repo carry trade, the most important leg is the longer term. This is the one with the longer duration, so the one which will account for most of the mark-to-market, said Porcheret.

The structured product market is a gigantic market – globally on Euro STOXX 50®, it is a $150 billion market. These products are transacted by dealers to retail and private bank clients and these products have an impact on the curve, due to dealers hedging them. These are bullish products for retail and private banking clients. Banks have no interest in being short the market, so they have to hedge this product. Because they are long-term duration, dealers need to buy back long-term forwards. When they hedge their product at inception, they buy forwards, and therefore lift the long-term spreads, Porcheret said. 

On top of that, depending on the direction of the spot, dealers will have additional needs of hedging, which will again impact long-term TRF spread, and hence the curve. Especially when the market goes down, they need to buy back more long-term forwards, which implies a further steepening of this term structure. If firms engage in trading long-term TRF for carry purpose, they have to keep an eye on this market, because this is the main driver. The first TRF product launched initially with five years, but extended fairly quickly to 10 years, because of the demand coming from the hedging of structured products, Porcheret adds.

TRFs and a new Approach

“This new instrument will push academics to go back to the drawing board, and rewrite the textbooks because the traditional approach doesn’t work anymore, it’s not in tune with reality,” said Professor Radu Tunaruat the University of Kent and author of a recent academic paper on Total Return Futures. “And I think there will be more developments coming out of this new other technologies. It’s a new technology that reflects market approach, not just a pure academic no-arbitrage approach,” he said.

*Prof. Radu Tunaru, Professor of Finance, University of Kent, Kent Business School, recently published a paper on “Total Return Futures” where he analysed this new asset class of derivatives which was introduced by Eurex Exchange to manage repo risks on equity markets. For more info on this paper, please watch ondemand webinar which includes Prof. Tunaru’s presentation on the highlights of his paper.

This article was first published on DerivSource on 13 November 2019.

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