The Killer App for Single-Stock Futures

Let's construct our own little SAT test:

Outright directional trade is to swap as:
a. Tip is to iceberg
b. Tail is to dog
c. Horn is to rhinoceros
d. All of the above

The answer is "d," all of the above. The fixed income, currency and physical commodity markets are dominated not by the outright buying and selling of goods, which both ties up and risks a lot of capital, but by swap transactions.

Swaps come in various forms. The one that stands ready to turn the world of equities on its ear is the total return swap.

At its most basic level, any swap is simply an exchange of cash flows and risk profiles. Swap participants don't exchange full payment. Instead, payments are made on periodic settlement dates, and default only risks the amount of the payments, not the much larger amount of the underlying notional principal.

The key words are "fixed" and "floating." A payment is fixed if its price is known and remains unchanged over the life of the trade. All futures contracts settle into a fixed price over the delivery period, and all stock prices are fixed at the moment the trade is executed.

A price is floating when it remains to be determined. This is quite common in physical markets with continuous delivery. Most natural gas contracts, for example, are based on prices floating with an index such as Gas Daily or Inside FERC. This is why the recent revelations of gas traders submitting phony prices to these reporting services were so damaging to the rapidly disappearing energy-trading business.

Swap participants fall into two categories: fixed-rate payers and floating-rate payers. In a bond swap transaction, a fixed-rate payer borrows at a fixed rate and lends at a floating rate; he is said to be short the bond and long the swap. This position will profit if interest rates rise. The floating-rate payer does the opposite, borrowing at a floating rate and lending at a fixed rate; he is said to be long the bond and short the swap. This position will profit if interest rates fall.