Islamic Capital Markets: Theory and Practice

Chapter 9

Stock Index Futures

This chapter explores techniques for using stock index futures in hedging strategies in Islamic capital markets. The chapter covers the specifications and the pricing of stock index futures contracts. It analyzes hedging with stock index futures and discusses the minimum risk hedge ratio; cross hedge; and targeting of beta and capturing alpha with stock index futures. The chapter addresses the construction of an indexed portfolio; asset allocation; the creation of a synthetic T-bill and a synthetic equity position using stock index futures. The chapter also covers portfolio insurance, index arbitrage, and program trading.

Stock index futures contracts are used to hedge against a bear market as well as to profit from a bull market. They provide portfolio managers with efficient instruments that save considerably on transactions costs in managing asset portfolios. In the absence of these futures contracts, hedging a portfolio would be a formidable and costly task that may require actual selling and buying of large amounts of stocks. With the availability of index futures contracts, managers can hedge portfolios without altering the actual composition of their portfolios and at a very low cost by simply buying or selling stock index futures. Stock index futures contracts are based on underlying stock indexes and therefore fall outright in the realm of the capital asset pricing model (CAPM), which is the most popular model in analyzing stocks. The hedge ...