An Introduction to International Capital Markets: Products, Strategies, Participants, Second Edition

15

Equity Index Futures and Swaps

15.1 CHAPTER OVERVIEW

Index futures contracts are widely used to take trading positions and to hedge the exposures on baskets of shares. This chapter explores how they are quoted, traded, and settled as well as the operation of the margin system. It presents a number of applications of index futures in hedging, trading, and asset allocation. It considers how index futures are priced and the effect of the cost of carrying positions in the underlying shares. This leads to a discussion of the cash-futures relationship, known in the market as ‘the basis’. A classic index arbitrage trade is assembled. Index and stock futures contracts are traded through exchanges and are standardized. Their equivalent in the over-the-counter market is the equity swap. The chapter looks at a standard or ‘vanilla’ equity swap and how the payments on the deal are calculated. It shows how equity swap traders can manage their risks using portfolios of shares or futures contracts. It explores the applications of equity swaps and also some important variations on the basic structure, including the floating principal deal.

15.2 INDEX FUTURES

An equity index futures contract is an agreement:

• made between two parties;

• on an organized exchange;

• to exchange cash compensation payments;

• based on the movement in the value of an equity index.

There is no physical delivery of the underlying portfolio of shares that comprise the index. This contrasts with commodity or bond ...