Abstract

This paper presents an overview of how single stock futures (SSF) have developed since their introduction in the United States. We present a number of reasons why individual investor interest in SSF may not have reached its potential. Individual investors should note SSF volumes are very low and implied interest rates indicate that SSF settlement prices often have little relation to their respective underlying stock's closing prices. We present evidence of a number of non-dividend paying companies with underlying stock prices that closed above the settlement prices of their respective SSF, contradicting the carry arbitrage model. © Academy of Financial Services. All rights reserved.

JEL classifications: G1; G11; G14

Keywords: Single-stock futures; Security futures

1. Introduction

The current financial landscapes in the United States and abroad have been changed by a number of recent innovations. One such innovation was the introduction of single stock futures (SSF) in the United States. SSF began trading in the United States on November 8, . The Commodity Futures Modernization Act of repealed the so-called ShadJohnson Accord and, after a 20-year ban, made it legal for individual investors to trade futures on single stocks and narrow-based indices (sector-based indices with three to nine stocks). Two principal regulatory bodies for stocks and futures, the securities and Exchange Commission (sec) and the Commodity Futures Trading Commission (CFTC), respectively, came to an agreement on how to jointly regulate these new securities.1

At present, three exchanges have been granted contract market designation to trade SSF: Nasdaq Liffe Market (NQLX), OneChicago, and Island Futures Exchange. However, only two of these exchanges, NQLX and OneChicago, currently have SSF trading. The NQLX was formed as a partnership between the NASDAQ Stock Market and the London International Financial Futures and Options Exchange (LIFFE). In June , NASDAQ sold its ownership in the joint venture entirely to Euronext.Liffe, a subsidiary of LIFFE. OneChicago is a joint venture between the Chicago Board Options Exchange (CBOE), the Chicago Mercantile Exchange (CME), and the Chicago Board of Trade (CBOT) and has been the most active exchange thus far. On the launch date, OneChicago listed 21 SSF, while NQLX listed 10 contracts on stocks of individual companies as well as four contracts on exchange traded funds (ETFs). Since the initial launch date, the number of contracts listed on these two exchanges has increased. On each exchange's Website, as of September , OneChicago lists SSF on stocks of 115 different companies, one ETF contract, and 15 narrow-based indices; while NQLX lists 56 contracts on individual stocks and two contracts on ETFs. Both of these exchanges continue to launch additional SSF contracts and contracts on narrowbased indices and to refine their product offerings.

This paper reviews the progression of the SSF market since its launch through November . We will present an examination of the successes, failures, and general development of SSF since their inception in the United States. In addition, the paper reviews the volume and the implied interest rates inherent in SSF prices and exposes many abnormalities in these measures that the individual investor should be aware of.

The individual investor should note that volume of SSF contracts on many days is quite low and may often be zero. In addition, the implied interest rates in many SSF closing prices are lower than theory would indicate, and the implied interest rates of many contracts are negative. The implications of these findings for the individual investor considering the use of SSF for hedging or speculating are that the lack of market activity may lead to poor order execution and fulfillment. Investors trading in these contracts will need to closely monitor the activity of the contracts that they wish to trade, compute the theoretical price of a SSF contract before entering a trade, and possibly place limit orders so that their order does not get filled at a price that is far from the theoretical value of the contract.

At the present time, using SSF as a hedging tool may be too expensive or impractical for many investors, especially those desiring to hedge a large position of stock (even as low as one million shares). Given the low volumes of many SSF contracts, an investor may not be able to trade a sufficient number of contracts at one time to fully hedge his or her stock position. This problem will be solved as volume increases and as more speculative investors look to SSF as an investment alternative. However, until volumes increase, investors desiring to hedge large stock positions must look elsewhere or be patient with the current market to fill their order flow.

There is currently no known literature that addresses the progress of SSF in the United States. Dutt and Wein ( ) examine the margin requirements on SSF imposed by the sec and CFTC and propose a risk-based margin requirement rather than the current strategybased requirement. Baptiste, Gao, Wang, and Yau ( , unpublished manuscript) investigate stock futures trading in Hong Kong and find low trading volume on stock futures contracts. Dennis and Sim ( ) and Lee and Tong ( ) analyze individual share futures in Australia; both find that the introduction of SSF does not dramatically change the volatility of the stocks underlying the share futures.

2. Development of the single stock futures market

The development of the SSF market to date has not been very impressive, as evidenced by the volume and open interest of SSF contracts, especially when compared to volume in the respective underlying stocks. There are a number of reasons why SSF may not be meeting prior expectations. One reason may be the relative newness of the market, which has prompted some confusion among brokers and individual investors. Salcedo (2005b) notes that "a major reason retail stock traders aren't trading single stock futures is their unfamiliarity with the new products." On November 4, , before the November 8 launch date, Barron's (Gibson, ) reported that many futures executives did not expect an "error-free liftoff," and that there would be a learning curve for many investors trading in SSF. Sisk ( ) reports that many financial institutions have waited to see how SSF have advanced and whether it will be worthwhile to direct investors to this market.

Additionally, there still seems to be confusion among market professionals and individual investors alike on many of the tax laws and their implications regarding SSF trading (Single Stock Futures, ). The majority of this confusion is related to portfolios that contain the underlying stock of the SSF being traded (for instance, trading SSF of 3M Co. in a portfolio that has 3M stock in it). Some brokers are even registered and willing to trade SSF for their clients but do not know the tax ramifications of trading SSF in the context of their clients' particular portfolios. Many brokers are also unsure of the conditions under which selling an SSF against a client's cash stock position will be considered a constructive sell, requiring the client to pay capital gains tax as if he sold the cash stock.

Current IRS rules state that a "gain or loss from (an SSF) contract will generally be treated in a manner similar to a gain or loss from transactions in the underlying security." These rules also state that "any capital gain or loss on a sale, exchange, or termination of a (SSF) contract to sell property will be considered short-term, regardless of the holding period" (IRS Publication 550, ). Common interpretation of this rule is that a long position held in a SSF contract for more than a year by an investor is taxed as a long-term capital gain, but a short position held for any length of time is taxed as a short-term capital gain (Simmons, ). However, other futures contracts, as well as dealers in SSF, are not taxed in this manner; they are taxed as 40% short-term capital gains and 60% long-term capital gains (IRC section 1256, ; IRS Publication 550, ). The difference between the tax treatment of SSF and other futures contracts may cause many investors to delay or totally avoid investing in SSF until the tax laws are clearer to them.

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