When you sell a single stock future, what does the MM do to hedge risk?

B

BinaryAlgorithm

The most obvious is to short the stock. However, for stocks with high dividends over the period, while the futures contract may be dividend protected, the short is exposed to having to pay the dividend which is more than is earned by taking the cash and putting it into bonds (what "theory" suggests sets the arbitrage-free value).

If for example I sell single stock futures with no interest built into the price at implied 0% rate (future = spot) and the stock is easy to borrow (0.25% for me anyway); I want to know what actually happens, and whether the MM (or any counter party really) can guarantee a profit in this situation.
 
BinaryAlgorithm said:
The most obvious is to short the stock. However, for stocks with high dividends over the period, while the futures contract may be dividend protected, the short is exposed to having to pay the dividend which is more than is earned by taking the cash and putting it into bonds (what "theory" suggests sets the arbitrage-free value).

If for example I sell single stock futures with no interest built into the price at implied 0% rate (future = spot) and the stock is easy to borrow (0.25% for me anyway); I want to know what actually happens, and whether the MM (or any counter party really) can guarantee a profit in this situation.
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The dividend is priced into the future if it's dividend protected, no?
 
No, the dividend is adjusted like a corporate event so neither party is affected by it (for this style of contract). The feature is called "No Dividend Risk" (NDR). Only the interest component affects the price generally. Thus, typically the future is priced a bit above spot for the stock.

Options hedge doesn't work as well in this case. I can buy 780 day puts (at about half the dividend's time value) and sell calls that don't overlap dividends (stop early exercise risk) to try to finance it, but these contracts can give me pure dividend exposure that I can leverage.

The main difference being that I get paid the risk free rate when I sell these futures, rather than having option time decay. They also don't require borrowing on margin like options in a portfolio margin account (around 2.3%).
 
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So you do understand that when a stock goes ex it drops by exactly the price of the dividend? So if you're short, you have to pay the dividend and get exactly the same amount back from the drop in price. So there is no "risk" for the MM to go short the stock if they're long the future you're referencing.
 
That's what I thought, but I'm not sure if that cash outlay affects them at all (probably not much). I've been trying to figure out why I can't find a counter party for a large number of NLY contracts, if I drop my price down to spot this should represent an arbitrage opportunity, no?

The objective was to reinvest the dividends each time growing the position by 2.5-3% per quarter (share growth rate depends on the yield at that moment), while maintaining zero directional risk using the futures.
 
BinaryAlgorithm said:
That's what I thought, but I'm not sure if that cash outlay affects them at all (probably not much). I've been trying to figure out why I can't find a counter party for a large number of NLY contracts, if I drop my price down to spot this should represent an arbitrage opportunity, no?

The objective was to reinvest the dividends each time growing the position by 2.5-3% per quarter (share growth rate depends on the yield at that moment), while maintaining zero directional risk using the futures.
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I don't think you're looking at this correctly, there's no way you can get the dividend on a stock without exposure to the directional risk precisely because the stock price drops by the amount of the dividend if you isolate out stock price movement. You're either misunderstanding how the no dividend risk feature works or how the stock price responds to a dividend. For example, let's say the stock is trading at $10 and you sold a future for $10.10 for a year from now with the .10 representing the interest. Assume the stock for some crazy reason never changes in price. Six months in there is a $1 dividend. The "no dividend risk" increases the settlement price at the end of the term by $1. At the same time, the stock will now be trading at $9 ex, because it drops by the exact amount of the dividend. Assume again the price doesn't change for any other reason and we get to the end of the year. The spot price is $9. You have to deliver a share to the buyer of your futures contract, but the settlement price isn't the current spot price of $9, its a share plus $1 per the "no dividend risk" mechanism. So it will cost you $10 to provide that share, just like it would have if there was no dividend. On the other end, the MM who went short to hedge would have had to pay a $1 dividend but be able to cover their short at $9 instead of $10, so they're at $10 as well same as you. It's all a wash, dividend or no dividend. If anything there may be a second order interest effect on the amount of the dividend that they had to pay Midway through the year but not recover until closing their short at the end of the year. This would be reflected in the $.10 premium you received when you sold the future originally, or at least their assumption of dividends would be accounted for in that.
 
Overnight said:
OMG Sig, man! Use ¶ !

My eyes, my eyes! Walls of text suck! :-(
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Point well taken:cool: I was only going to post the first two sentences, but decided it deserved a better explanation and never went back to reread it as a whole. And so you got what you see here, sorry!
 
Overnight said:
Well, edit the thing, make it look readable! you have 30 mins left to edit it.

I shall taunt you with an old Amazon commercial until you fix it!

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I know but then no one will understand what we're fapping on about.

And that was way more painful than my "wall of text"!
 
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