Derivatives

CHAPTER 6Strategies: Stock Index Futures

Aims

• To show how stock index futures can be used to protect an active ‘stock picking’ strategy from general movements in the overall stock market return (e.g. S&P 500 index).
• To demonstrate how an investor (e.g. long-short hedge fund) holding a well-diversified portfolio of stocks can benefit from speculating on underpriced or overpriced stocks, while also using stock index futures (SIF) contracts to hedge the impact of any unexpected movements in the market return (S&P 500) on the stock portfolio.
• To show how the ‘effective beta’ of a stock portfolio can be altered using stock index futures. This enables investors (mutual funds and hedge funds) to implement a ‘market timing’ strategy, using stock index futures.
• To show how hedge funds engaged in ‘merger arbitrage’ can slowly purchase the stocks of a prospective takeover target but also protect themselves from rising prices for the target firm caused by an unexpected increase in the overall market return (S&P 500 index).

6.1 UNDERPRICED STOCKS: HEDGING MARKET RISK

Stock index futures (SIF) can be used to protect your speculative ‘stock picks’ from general changes in the overall stock market (e.g. S&P 500 index). For example, the hedge fund MoneyPlus takes on risky bets that are potentially profitable – but it also tries to hedge any risks it feels it does not have the information and skill to handle. Suppose MoneyPlus thinks a drug company called MaxPill will soon be getting a favourable ...