Derivatives

CHAPTER 5Index Futures

Aims

• To provide details of contract specification, settlement procedures and quotes for stock index futures contracts.
• To demonstrate index arbitrage and program trading using stock index futures.
• To price a stock index futures contract, when stocks which make up the cash market index (e.g. S&P 500), pay discrete dividends.
• To determine the number of futures contracts to use when hedging various cash market positions (e.g. a portfolio of stocks or holding barrels of oil).
• To outline the risks which remain, after hedging with index futures.
• To demonstrate ‘tailing the hedge’.

Stock index futures (SIF) are contracts whose price depends on an underlying stock market index such as the S&P 500, FTSE 100 or Nikkei 225 indices. Such futures contracts are widely used in hedging, speculation, and index arbitrage.

In a well-diversified portfolio of stocks, specific (idiosyncratic) risk of individual stocks has been largely eliminated and only ‘market’ (‘systematic’ or ‘non-diversifiable’) risk remains. Stock index futures can be used to eliminate this ‘market risk’ of the portfolio of stocks. In ‘normal times’ a fund manager might be quite happy to hold a diversified portfolio of stocks even though they are risky. But if a fund manager believes the market will become increasingly volatile over the next 3 months (i.e. could rise or fall substantially) and she wished to remove this uncertainty, she could sell stock index futures to eliminate the market risk. At the ...