The Killer App for Single-Stock Futures

Taxes

Taxes create trading opportunities. A large number of institutional investors, such as pension funds, are tax-advantaged, as are offshore hedge funds. These accounts should prefer to receive their returns more in dividends than in capital appreciation, as the dividend stream is untaxed and the lower capital gains tax rates do them no good. Moreover, the dividend income both lowers the risk of holding the stock and can be reinvested at the holder's discretion.

The setup is now clear: A tax-advantaged investor should want to swap capital appreciation for current income. If a low- or zero-dividend stock is appreciating rapidly in price, as many tech stocks did in the late 1990s, the total return may be quite high. This may delight risk-seeking investors in high tax brackets, but not tax-advantaged investors. The swap counterparty, the fixed-rate receiver, may be a conservative investor with large current income needs, such as a life insurance company.

A total return swap monetizes capital appreciation. Our tax-advantaged investor can get paid on the period's total return even if the stock is neither sold nor pays a dividend. The downside of this position, of course, is that he will have to pay the insurance company if the stock's total return falls below the low end of the target range. Effectively, our tax-advantaged investor is long an out-of-the-money call and short an out-of-the-money put and is paying a LIBOR-plus premium to the insurance company as part of the swap.

In return, the insurance company will get paid a return over LIBOR. Its risk is now converted from being long equity to being long a high-yield bond plus a long put/short call option combination opposite of that of the tax-advantaged investor.

Both parties can price this swap and hedge their risk by buying and selling a strip of single-stock futures. The insurance company can buy the strip to hedge paying against a positive total return, and the tax-advantaged account can sell the strip to hedge paying against a negative total return. If other financial markets provide a valid basis for comparison, we should see numerous strip trades back and forth for strips of single-stock futures.

The flurry of activity will provide liquidity for individual traders in single-stock futures, just as bond swaps provide liquidity in T-bond futures. Total return swaps therefore will be the "killer app," to borrow from the technology lexicon, for single-stock futures.

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