Special risks of Exchange For Physical (EFP) products

Overview: 

The following article discusses the special risks associated with hedged financing transactions which employ the traditional OneChicago single stock future contract (designated by product symbol suffix of "1C") which is eligible for adjustment on special dividends or distributions but not adjusted for ordinary dividendsThe particular risk described below can be avoided through use of the Exchange's dividend protected or NoDiv product (designated by product symbol suffix of "1D") which are adjusted to remove the impact of all dividends.

Discussion:

Account holders transacting in EFPs, including Low Synthetic Yield positions using the OneChicago traditional single stock future ("1C" product) are advised to pay particular attention to the risks inherent in such positions, the effect of which may be to significantly alter the cost of the position.  These risks generally originate from corporate actions, specifically those involving a distribution to the holder of record for the stock with no corresponding adjustment made to the futures contract deliverable.

 
As background, a Low Synthetic Yield position, or EFP purchase, consists of a long single stock future coupled with a short underlying stock position. Traders maintaining this type of position are typically seeking to avail themselves of market implied borrowing rates which are more advantageous than those quoted by carrying brokers (i.e., the stock is sold and bought forward at a net carrying cost which is lower than that of the available lending rate). In certain instances, however, the single stock future may be trading at parity or even at a discount to the stock price, seemingly implying a no-cost loan of the short sale proceeds and/or a locked-in profit from selling the stock at a higher price today than that which one will be obligated to deliver at in the future. 
 
Take, for example, the ING Group N.V. (ADR) EFP.  On October 29, 2009, the stock was quoted at $13.29 and the Dec '09 future at $12.50, an implied annualized discount of approximately 43%. While the ability to sell the stock then at $13.29 and buy it back at a 51 day forward price of $12.50 appeared to guarantee a locked in profit of $0.79 per share (excluding commissions and any carrying costs), traders would also have had to take into account the likely impact of the firm's announcement three days prior of a restructuring plan which included the issuance of rights providing for repayment of a capital injection made by the Dutch State.  Under the terms of this plan, announced to the public on November 18th following European Commission approval, shareholders of record as of November 27th were to receive a distribution of non-transferable rights on November 30th.  
 
Also critical to the risk of this position was the determination announced by OCC's Securities Committee on November 23rd that no adjustment would be made to the futures contract.  As a result, traders maintaining a Low Synthetic Yield position comprised of the long future and short stock held through the ex-date of November 24th, were obligated to deliver the rights on November 30th (then priced at approximately $3.32 per share) to the stock lender with no offsetting adjustment made to the long future.  The effect of this corporate action upon traders initiating a single EFP position at the October 29th prices quoted above and exiting all positions at the November 30th closing prices would not have been to realize a gain, but rather sustain a loss (excluding commissions and any carrying costs) of approximately $254.00.  A summary of this transaction is provided below.
 
Product/Action
Cash
Stock
-Sell 100 @ $13.29 on 10/29/09
-Buy 100 @ $9.50 on 11/30/09
Net
 
 $1,329 
 (950)
$379 
Future
- Buy 1 contract @ $12.50 on 10/29/09
- Sell 1 contract @ $9.49 on 11/30/09
Net Variation
 
 
 
 
 
($301)
Right
-Buy 100 @ $3.32 on 11/30/09
 
($332)
Totals
($254)