The long and short positions are from the point of view of the box spread buyer. Combining the long call and short put options struck at 100, the box buyer will acquire the underlying futures at a price of 100 after the exercise assignment process, regardless of where the underlying futures is trading at the time. Similarly, with the short call and long put options struck at 2100, the box buyer will sell the underlying futures at a price of 2100. 

The two underlying futures transactions will net against each other, resulting in no open futures position, and 2000 index points in cash paid to the box buyer. With the multiplier for each E-mini S&P 500 Index futures being $50, each options box spread is worth $50 x 2000 = $100,000 at the expiration.

Since the cashflow at the options expiration is a fixed sum, the box spread is effectively a fixed time deposit, with the current net options spread premium (price) being the discounted value of the payout at the expiration. In the example above, the net premium was 1996.15 index points, or $99,807.50. Interest rate calculations will be discussed in the ensuing section.

From the point of view of the seller of the box spreads, the trade is effectively a borrowing facility. Sellers receive cash premium and repay the fixed sum at the expiration of the options. In order to free up the cash premium, acceptable (non-cash) collateral is required to be pledged. Collateral management will be discussed later in the article.

A few comments about the box spread structure are in order:

• For each box spread, the value of the box depends on only the difference between the two strike prices as well as the multiplier for the contract. A 2,000-point strike differential has been a very popular choice for boxes constructed from E-mini S&P 500 Index futures options, as it equates a financing amount of $100,000 (= $50 x 2,000). As a result, the strike price pair of 200 and 2,200 will have the same result as the strike price pair of 100 and 2100; or, for that matter, the strike price pair of 4,000 and 6,000.

• Historically, capital treatments at the Futures Commissions Merchant carrying the positions could differ depending on the choices of strike prices. Whereas capital requirements were calculated based on the notional value of the position, lower struck options would carry a lower notional value and thus require lower capital requirements on the part of the FCMs. While most of the capital requirement determination are no longer tied to the notional value of the options, the practice of using lower-struck options persists. Indeed, the 100-2100 boxes have been far more prevalent than any other 2,000-point boxes.  As a result, CME Group lists the 100 and 2100 strikes and well as popular box options expirations.
  
  For the box spreads to be an effective financing tool for the sellers, the options should only be exercised (or exercisable) on the desired expiration date. As such, only European options exercisable on their expiration days should be used to construct box spreads. American options, which are exercisable on any business day up to the expiration day, are not advisable. The buyers would be very tempted to exercise the two in-the-money options legs if they were allowed to do so, thus calling back the loans with substantially all the “interest” immediately and thus unraveling the financing trade right away. This is particularly true if the strike prices are “deep in the money”, as in the example above.

• It is also critically important that one and only one of the options for each strike in the box spread is exercised/assigned at the expiration for the ensuing futures positions to net down. The exercise/assignment rules of the European-style options on E-mini futures at CME Group stipulates that:
  1. the exercise/assignment is determined by a Volume Weighted Average Price of the underlying futures (known as the fixing price) at the moment of option expiry;
  2. if the fixing price is equal to or above the strike price, the call options are exercised and the put options expire worthless; conversely if the fixing price is below (but not equal to) the strike price, the put options are exercised and the call options expire worthless;
  3. the exercise/assignment are automatic based on the preceding rules; contrarian instructions are not allowed.

As a result, the four options will definitively result in the two offsetting futures transactions due to the exercises/assignments^[1], even if the fixing price on the expiration day falls right on top of either strike prices.

• The European options expiring at the close of business on the third Friday of quarterly months, which are futures expiration days, are written on futures contracts expiring on the third Friday three months hence. As the options exercises/assignments result in offsetting futures positions, the fact that the underlying futures is of the next quarterly contract month is of no consequence. The box spreads will work as intended. 

Implied interest rate calculation of box spread trades are analogous to any other fixed income instrument. Assuming an ACT/360 day-count convention, the interest rate and net options premium is related by the following equation:

As with any discount instrument, the net premium and the implied interest rate are inversely related. A higher premium means a lower interest rate, and vice versa.

There are a few nuances of the calculations:

The number of days in the equation is determined by the timing of the cashflow^[2] and is not necessarily the same as the number of days to options expiration.

On the options expiration day, the exercise/assignment of the options occurs after the close of business, with the resulting cashflow paid/received on the following business day. In the example above, the expiration day is Friday, April 5, 2024, with the following business day being Monday, April 8, 2024.

With the inception trade occurring on March 25, 2024, the timing of the net option premium payment depends on the execution time of the trade. For trades executed before mid-morning and cleared prior to the intra-day clearing cycle at CME Clearing, net premium is included in the same day variation margin payment at the end of the day. For trades cleared after the cut-off of the intra-day cycle, net premia are included in the next day morning cash payment. 

Since the trade in the example was consummated and cleared after the intra-day cycle cutoff, the net premium was paid on March 26, 2024. The number of days equals 13. A net premium of 1996.15 implies an interest rate of 5.341% p.a. using the ACT/360 day-count convention. 

The net options premium is subject to minimum tick increments for the corresponding options markets. For a block trade in options on E-mini S&P 500 index futures, the minimum increment is 0.05 index points.* The rate sensitivity of a 0.05 index point change in net premium is 0.0695% p.a. for the example above.  

Generally speaking, the precision in the implied interest rate can increase (i.e. lower basis point value) with a wider strike price differential. This is particularly true of boxes with shorter expirations as the number of days between cashflow shrinks.

Turning over to the seller side of the trade, as has been mentioned earlier, the transaction functions as a way to receive cash premium at the inception and repay the full value of the box spread at options expiration. In order to free up the cash premium received on the sale of the box spread, however, acceptable collateral needs to be posted at CME Clearing.

In particular, U.S. Treasury Securities are acceptable collateral – subject to appropriate level of “haircut”^[3]. As of this writing, U.S. Treasury notes/bonds with 10-year of remaining maturity are subject to a haircut of 4.5%, i.e. performance bond requirement can be met by market value of the security after discounted by the haircut percentage, thus freeing up the cash proceeds for withdrawal. The haircut level can be thought of as an over-collateralization requirement, which varies based on the pledged securities. At the options expiration, the box seller repays the loan, freeing up the pledged securities.

This arrangement is reminiscent of a tri-party repo transaction in the capital market, in which CME Clearing acts as a third-party custodian of the collateral. The buyer of the box spread pays the premium in cash and receives the fixed payout at the expiration. Effectively, the buyer lends the money for the balance of the option’s life. Conversely, the seller of the box spread takes a cash premium and repays the fixed payout at the expiration. Effectively, the seller borrows the money. 

CME Clearing performs a very important function in this trade. From the perspective of the buyer or lender, it guarantees the performance of the borrower. This guarantee is made possible by the Clearing House demanding and holding a suitable amount of collateral from the seller or borrower. 

Further, box spread long holders can, in turn, utilize the “open equity” in the box spread position for margin offset purpose for the other options and futures positions at the Clearing House. Schematically, the credit relationship resembles the following:

 Box spreads enjoy several advantages over the traditional term repo.  

• Net margin requirement – from the borrower’s perspective, the performance bond requirement is a single number that encompasses the requirement for all positions held at the Clearing House. A margin surplus in the rest of the portfolio can be applied to the collateralized borrowing using box spreads. Conversely, the lender will enjoy the margin offset afforded by the long box spreads position to fulfill performance bond requirements for the rest of his positions in futures and options.
• Substitution of collateral – the borrower may desire to substitute collateral underlying a repo transaction. If it were an unintermediated repo, the lender would have to be involved in the substitution – wiring out the old collateral and receiving the new collateral, etc. In the case of these box spreads, the lender is literally facing the Clearing House, leaving the duty of interfacing with the borrower to the Clearing House. Therefore, when the borrower decides to substitute collateral, the lender will not be involved.
• Clean close-out trades – novation of these option boxes to the Clearing House allows for clean close-out trades. If either the lender or borrower wishes to close out the collateralized lending or borrowing early, they only need to sell or buy back the options boxes in the market. The novation process will net the existing positions with the closing trade^[4]. Again, the original counterparty does not need to be involved.

The following two charts show the history of the 90-day and 30-day implied rate of the E-mini S&P options box spreads over the period when the Federal Reserve was actively adjusting the Fed Funds target from virtually zero to the current level of 5.25-5.50%. Unsurprisingly, both 1- and 3-month Term SOFR rates increased during the period accordingly. 

The box spread rates with comparable maturities also experienced corresponding increases during the same time frame. Generally speaking, box spreads traded at a slight premium to the Term SOFR rate, with the 30-day and 90-day box spread rate at a median premium of 31 bps and 20 bps over 1- and 3-month Term SOFR respectively. As a result, box spreads appear to be offering yield pickup opportunities.

Note that the rates are derived from the daily settlement prices of the E-mini S&P options on futures. Since December 2022, the daily settlement prices incorporate the “risk free rate” information from the options box spread market. As a result, the daily settlement price curve provides a reasonably good estimate of the prevailing rates, especially on the short-end of the expiration schedule where box spread trades are quite active. 

While the rate spread between the box rate and the Term SOFR seem very volatile, the trend was very reasonable. When the regional bank crisis was raging in Q1 2023, the spread came in significantly for both 90-day and 30-day box spreads. Indeed, the performance is guaranteed by CME Clearing and the extra degree of certainty was valued.

In fact, the Regional Banking Crisis witnessed an initial jump in the box spread trading volume that led to a visibly higher trading volume for the product – from under $100 million a day to the current average of $300 million+ a day.

During Q1 2024, much of the box spread trading was concentrated in short term maturities. Over 80% of the trades employed instruments expiring within a month. The vast majority of the trades employed instruments expiring within six months. 

In terms of trading venue, just over 1/3 of the trades by value were consummated electronically on GLOBEX and the remaining 2/3 were block traded. The electronic/block split was virtually identical across the maturity spectrum.

The following screenshot shows the Globex order book for 100/2100 box spreads expiring on April 19, 2024 on the afternoon of March 26. Globex permits the creation of user defined options spreads as well as the subsequent issuance of Request For Quotes (RFQs). Upon the creation of the User Defined Spread (UDS), a central limit order book (CLOB) for the instrument is created. Market participants may react to the RFQ and populate the CLOB with their bids and offers, as shown in the screenshot.

At any moment, there could be multiple box spreads with the same expiration date but different strike combinations in the market. Market participants may inspect the list of UDS to see if one of the existing instruments matches their interest.

Box spreads of E-mini S&P futures provide a good cash investment opportunity as well as a reliable means of financing for market participants. It appears the recent uptick in activities is sustainable. Market participants should consider the increased liquidity it is providing to the short-term capital market.

^[1] For more details of the options exercise/assignment procedure, please consult the relevant product rule chapter in the exchange rule book. Please note that the discussion in this document is true of options on E-mini index futures. For other options at CME Group, please consult the relevant product rule chapters to ensure the applicability of the exercise/assignment rules discussed herein.

^[2] The cashflow date discussion is true of those between CME Clearing and the FCMs. To the extent market participants might have a different arrangement with their FCM, please make appropriate adjustments to the calculation.

^[3] Please consult CME Clearing’s collateral management webpage for acceptable collateral and associated haircut schedule.

^[4]Of course, the closeout trade will be done at the current market rates. To the extent the box spreads behave like any other discount instruments, principal losses are possible.

* Footnote: For Globex trades, since the net premium will far exceed the threshold for the 0.05 index point tick increment, box spreads are quoted in increments of 0.25. For block trades, the price of each of the 4 legs can be specified directly. There is always a leg at a low enough premium to trade at the 0.05 increment.