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Development of the EURO STOXX 50® Index Quanto Futures at Eurex
Development of the EURO STOXX 50® Index Quanto Futures at Eurex
On 21 March 2016, Eurex launched the USD denominated Quanto Futures on the EURO STOXX 50® Index. One year later, in March 2017, open interest in this product has reached USD 1 bn notional. This note summarizes the development of the first year, including new product enhancements and applications.
First, what is a Quanto Futures?
A quanto is a type of derivative in which the underlying is denominated in one currency, but the instrument itself is traded and settled in another currency. The EURO STOXX 50® Index Quanto Futures (Eurex Product ID: FESQ) is the exact copy of the highly liquid EURO STOXX 50® Index Futures (FESX), with the exception that it trades in USD. Both contracts expire at the exact same index level (Bloomberg code: SX5E) on the third Friday of March, June, September or December. However, whereas each contract held in FESX will deliver the owner the index level x EUR 10, each contract held in FESQ will deliver index level x USD 10.
|Name||EURO STOXX 50® Index Futures||EURO STOXX 50® Index Quanto Futures|
|Underlying||EURO STOXX 50® Index (Bloomberg code: SX5E)|
|Multiplier||EUR 10||USD 10|
|Tick size||EUR 1||USD 1|
How do the valuations of the two futures differ?
In comparison to the fair value of the FESX (where only dividends paid on stocks in the index and current interest rates are considered), the fair value of the FESQ is further defined by the volatility of the underlying index and the EUR/USD exchange rate, as well as by their correlation. This determines the so-called “quanto spread”. With increased volatility of the EURO STOXX 50® Index or with increased volatility of the EUR/USD exchange rate, the “quanto spread” will increase, too. However, when the correlation between these two increases, the "quanto spread" will go down. This inverse relationship can be observed at beginning of March 2017, when the correlation of equity and exchange rate turned positive, and the "quanto spread" between FESX and FESQ at the shorter end of the term structure turned negative. The graph below shows the "quanto spread" (defined as the difference in the daily settlement prices of FESQ and FESX, in index points).
What are the main product applications?
As described in the previous section, the main difference of the FESQ is that it is denominated in USD (vs FESX in EUR). Given this essential feature, there are two main reasons to use the product:
- Separate equity and FX return: invest in European markets without being exposed to the Euro currency. The Euro performance is naturally embedded in the FESX. On the other hand, the FESQ offers a separation of equity and FX performance. This is generally interesting for investors with a US Dollar preference. This type of trade is particularly popular during pronounced monetary policy discrepancies, Quantitative Easing (QE) programs1 and the consequent effect on equity markets and the exchange rates of the main currency pairs.
- Hedge quanto risk of structured products: issuers of quanto structured products can use Eurex Quanto Futures to hedge their quanto risk. To extract the quanto spread, an issuer will typically trade FESQ against FESX in the same notional and maturity, i.e. without the delta component. These structured products are often issued with longer maturities (up to 10 years), therefore FESQ hedging is done in expiries further out (e.g. currently available Dec17 or Dec18).
1 A prominent example was the so-called "Abenomics" expansive monetary policy in Japan, which affected positively the Japanese stocks indices, however simultaneously depreciated the Yen against the US Dollar. A similar QE effect was subsequently seen in Europe.
Volume development and its drivers:
Since the launch of the Eurex Quanto Futures back in March 2016, more than 90,000 contracts have traded, corresponding to over USD 2.7 bn notional. In most cases a trade in the same size in the FESX was done as a hedge, doubling the traded notional.
Macro events generally drive volumes - this is shown in the chart below. After a good start in March 2016, activity decreased post the Brexit referendum, as the correlation, which prior to this was very negative, jumped back towards zero. Volumes only picked up again with the US elections in November 2016. The market anticipates another pick up around the European elections in 2017, with French elections seen as the biggest driver.
In the long term, we expect the first product application, i.e. investing in European stocks, but avoiding exposure to the Euro, to be the main driver behind the volume growth. However, the right macro environment (e.g. expansionary monetary programs) and orderly liquidity are prerequisites for this growth. Another volume driver is the hedging of the "quanto risk" done by banks via the inter-dealer market. This is typically a market dominated by banks looking to transfer this quanto risk. An exchange-listed product like the FESQ opens up the market to investors seeking exposure to equity - FX correlation and volatility (e.g. hedge funds, such as global macro funds who might take an opposite view and want to speculate on the correlation), therefore balancing the market.
Lastly, the new margin regime for non-cleared OTC traded derivatives and subsequent higher costs for banks to trade off exchange should make the exchange listed product more cost effective and incentivize a shift from the OTC market. A similar trend has been observed in the past with the dividend derivatives and is increasingly happening on EURO STOXX 50® Index Total Return Swaps and MSCI products.
To offer further hedging opportunities, since February 2017 quarterly expiries in both FESX and FESQ are available out to two years (previously only 9 months). Furthermore, Eurex also now allows more granular trading in the "quanto spread", by reducing the minimum block trade size for the FESQ and opening up the EFPI functionality to allow lower sizes to trade as a hedge in the FESX. This means the "quanto spread" can be entered not only in full ticks, but also in smaller price steps, as is the practice in the OTC market.
Once the trading activity in the EURO STOXX 50® Quanto Index Futures has largely moved on exchange, Eurex could consider product extensions, offering options or futures in additional currencies.
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