AIR TRFs are designed to be an on-exchange alternative to an OTC equity total return swap (TRS) and are used for the following primary reasons:

1. Portfolio management – To facilitate trading of index exposure over longer maturities by mitigating both dividend risk and fixed rate financing risk. The capital efficiencies and product transparency available make them a useful alternative to a TRS. For a deep dive on how AIR TRFs offer similar economics to a TRS, please see here.
2. Positioning opportunity along the curve – By trading a calendar spread in the product, investors can isolate the equity repo level of the underlying index and trade along the equity financing curve. To learn more on why an investor may choose to trade the equity financing curve, please see here.

Adjusted Interest Rate Total Return futures (AIR TRFs) have seen rapid adoption by the marketplace since their introduction in September 2020. With open interest growing to over 400k contracts across the AIR TRF suite at CME Group, equivalent to around $100B notional, as of November 14, 2023.

AIR TRFs have been designed with standardized features to offer similar economics and characteristics of a bilaterally negotiated TRS with an embedded floating rate. The innovation of the AIR TRF futures was constructing an embedded floating rate to offer an economic return profile analogous to a traditional equity swap (see Exhibit 2).

Thus, AIR TRFs provide investors with a highly margin-efficient futures exchange traded product that delivers total return exposures to equity index investors. This means the value proposition of the AIR TRF is that both the underlying financing rate and the equity index level adjust daily.

Source: CME Group, SPTR - S&P 500 Total Return Index, where dividends are re-invested

A feature of AIR TRF is that it provides the marketplace with transparency of the equity financing level of a given index for different maturities. In both the AIR TRF and TRS^[1] structure, the selling of equity index returns gives rise to a funding cost – whereby the seller, borrows funds at the prevailing rate to purchase the underlying equities needed to replicate the index performance (see Exhibit 3). Therefore, the seller must be compensated for such costs by the buyer of the equity leg who receives the index exposure without needing to purchase the underlying assets. The cost of funding equities is determined by the supply and demand of the user base on both a daily and a term-basis, where the financing level can change.

The remainder of this article peels the layers of CME Group AIR TRF and specifically outlines the differences which exists between an investor trading an AIR TRF and a synthetic equity forward.

Investors have traditionally often used synthetic forwards to trade equity exposure further down the maturity curve and one motivation has been to trade equity financing and explicitly the equity repo level of the underlying equity index. Similarly, many participants are now choosing to trade AIR TRFs to isolate the equity repo level, however there are some important differences between the two products’ design and valuation.

AIR TRFs help users who wish to manage longer-dated equity exposures without the complication of pricing in dividend risk or trading fixed-rate financing.

Equity index repo levels can be isolated by trading a calendar spread in the AIR TRF. Essentially, many of the economic terms between the long and short position of the calendar spread cancel out (as long as the two contracts are held) and the remaining exposure is the repo spread to the underlying financing rate at each maturity traded.

In an AIR TRF, the equity index component is an agreement between two counterparties to pass equity performance from one counterparty to the other. Additionally, the equity leg is resetting daily in terms of the daily financing component at the overnight rate. These daily rates can differ because interest rates can change over time. This is the first important difference to highlight when comparing AIR TRF to an index forward.

In a forward, both the equity strike and the all-in financing rate are fixed for the duration of the trade. Note, the all-in financing rate consists of both the underlying financing rate or risk-free rate often referred to as “r” in formula such as in Exhibit 4 and also the repo level, “q” term in Exhibit 5.

A second important difference is the valuation of the repo parameter in each product. In an AIR TRF the repo level is accounted for by what is known as the TRF Spread to the underlying financing rate. This can be seen from the next section which details the AIR TRF valuation including this repo element which is treated on a simple basis in the third component term of an AIR TRF known as the Financing Spread Adjustment (FSA).

However, in a forward this parameter is treated on a compounding basis. The magnitude of this difference in valuation grows as the maturity of the product traded increases. Thus, this is another important nuance to consider when trading equity index repo via an AIR TRF versus a synthetic forward.

A third difference is that the majority of synthetic forwards are traded on a price return index. This means dividend risk is present and needs to be managed alongside a forward trade if the intended goal is to isolate equity repo levels. The underlying index used in an AIR TRF is total return meaning that dividend risk is mitigated.

The valuation of the AIR TRF and index forward is depicted in the formulas below, (see Exhibits 4 and 5). 

AIR TRFs have a maturity at a known date and its valuation has three components: 

1. an equity index component, 
2. a financing component that accrues daily,
3. a financing spread adjustment component.

The equity index price of the AIR TRF is based on the official index daily close, and it is important to note the traded element is the TRF spread quoted in basis points which is transacted via BTIC^[2].

In exhibit 4, the S&P 500 AIR TRF spread adjustment is calculated on a simple basis, in other words, there no discounting for the TRF spread.

The TRF spread is defined as the spread over or below the financing reference rate (EFFR – Effective Fed Funds Rate) that market participants determine as the cost to fund the equity index exposure and it is expressed in basis points, s_t. The AIR TRF spread to the financing rate is fixed at the inception of the trade. 

A synthetic index forward (sometimes referred to as a combo) is a purchase (sale) of an index option call and sale (purchase) of an index option put with the same quantity, underlying index, expiration date, and strike price, usually at zero-cost. 

Index forwards can be expressed as follows:

As noted previously, the forward has the equity strike level and the all-in financing costs consisting of both the interest rate and the equity index repo level fixed for the duration of the trade.

Market participants need to be cognizant that there are distinct valuation differences when comparing AIR TRFs with index option forwards as summarised in Exhibit 6.

The simplicity of the AIR TRF product is leading to greater adoption by market participants, as evidenced by the rapidly growing average daily volume (ADV) and open interest (OI). This is true of those looking to trade equity index repo as they migrate away from synthetic forwards and benefit from the growing liquidity pool available in AIR TRFs.

Source: CME Group, basis points – bps

The latest accrued financing amount for each AIR TRF contract is published daily and available via an online calculator, which is able to convert the price of any TRF spread into the AIR TRF price once the closing index level for the day is known.

QuikStrike calculator: The Accrued Financing number is populated within the calculator available here.

AIR TRF Datafiles:

• Via the Firm FTP Server (SFTP), in the pub/settle/air directory
• Via email: write us at ccs@cmegroup.com to sign up.
• Via EREP: see report IDs AIR_TOP and AIR_COMP
• Via CME DataMine at cmegroup.com/#/datasets/cme.air

Settlements & Valuation Channel: Via the Data Insights: Settlements & Valuation Channel ID 251, part of CME Group’s Market Data Platform. View details here.

AIR TRF futures contracts are on-exchange and marked-to-market on a daily basis whilst forwards usually involve posting collateral and are valued at the end of term. Another key difference is default risk. Futures contracts are traded on a recognised exchange and the clearing house guarantees the contracts. The default risk is in the event that the clearing house is unable to honour its commitments. Forward contracts are sometimes over-the-counter contracts, and the default risk is that the parties involved may default. Since bilateral OTC contracts are entered into and settled on a principal-to-principal basis, each party is exposed to counterparty credit risk, which is mitigated in the case of exchange traded derivatives. It should be noted that not all index forwards are OTC; some are exchange traded.

Considering both an index forward contract and a futures contract with a common delivery date. When one considers the cash flows to these contracts, the forward contract only has a cash flow at delivery, while the futures contract has daily cash flows due to marking-to-market. The cash flows to the futures contract at each date is the change in the futures price over the previous day and the overnight interest rate.

A feature of futures contracts is that the positions of both buyers and sellers of the contracts are adjusted daily for the change in the market that day. For AIR TRFs this is both at the equity index level and actual interest rate which is realized. This is not the case in the forward.

In a futures agreement, there is no payment made by the buyer to the seller, nor does the seller have to show proof of physical ownership of the asset at the time of the trade. In order to ensure that the parties to the futures contract fulfil their sides of the agreement, they are required to deposit funds in a margin account. The amount that has to be deposited at the time of the contract is called the initial margin. As prices move subsequently, the contracts are marked to market and the profits or losses are posted to the investor’s account. The investor is allowed to withdraw any funds in the margin account in excess of the initial margin. The investor is expected to maintain a maintenance margin.

In a forward contract, the buyer and seller are counterparties who negotiate a contract that obligates them to trade an underlying asset at a specific price on a certain date in the future. When it is a private contract, it is not traded on an exchange but over the counter. Collateral is usually posted at inception, but no cash or assets change hands until the maturity date of the contract. This could be depending on if the contracts are listed and rules-based margining is in place like at an exchange, or CSA based OTC bilateral margining, or tri-party. Note that there are forwards comprised of on-exchange combos as well.

1. TRS - In a total return swap, one counterparty agrees to pay total index performance to the other in exchange for an agreed financing payment. The counterparty that is long equity performance (the "receiver") receives the index performance inclusive of dividends and pays the financing costs to the counterparty who is short (the "payer") to compensate them for the financing and funding costs associated with purchasing the underlying equity position.
2. BTIC – Basis Trade at Index Close
3. Please refer to this link for the derivation and explanation of the AIR TRF.