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Interest Rate Cost Comparisons Between Stocks And Single Stock Futures

by Howard Simons, NQLX's Special Academic Advisor.

Selling stock short can be a difficult and laborious procedure. First, you have to locate a supply of stock to borrow. This takes time. Next, you have to pay the broker loan rate on your borrowings. Broker loan is one of the highest short-term interest rates.

If the stock in question is difficult or impossible to borrow, a short squeeze can result. Here prices can surge higher without limit as those who have borrowed the stock try to buy it back. Short squeezes are common in new issues with a relatively small number of shares outstanding or in thinly traded issues.

Single stocks futures (SSFs) should simplify this procedure and reduce its costs. To take the equivalent of a short position in the stock, all you need to do is sell the future. The supply of futures, its open interest, can expand indefinitely. The short party to a futures contract is obligated to deliver the stock at expiration, but you can offset prior to expiration by buying the future back. Stocks and futures will settle within the bounds of transaction costs on the last trading day. Also, you can roll your short position forward into another delivery month if you wish.

Quantifying The Difference
In the absence of a special situation related to a short squeeze, a SSF generally should trade at a basis over the stock equal to the repurchase ("repo") rate minus the future value of the expected dividend. That means you earn money at the rate of [repo-dividend] on a short futures position.

In comparison, the short seller of a stock will pay the broker loan rate and any dividends due. However, the seller will receive the proceeds of the short sale, and these funds can earn interest. If we net all of these out, we see that a real advantage for selling short via SSFs would have existed over most of recent history. The aggressive cutting of short-term interest rates by the Federal Reserve in 2001 shifted the advantage back to the short sale of stock; whether this is a temporary phenomenon or not is not for us to say.

We can perform a similar analysis for the SSF's advantage for the buyer. A long SSF position is paying the broker repo rate and receiving the dividend. A stock buyer facing the 50% margin of Regulation T will be borrowing at broker loan over this portion; the margin deposit can be in interest-bearing securities.

The introduction of SSFs will change these historic relationships. Because markets don’t allow arbitrage opportunities to exist indefinitely, we could expect stock loan departments to lend into whichever market offers the highest return until that return disappears.

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