In the previous chapter, the basics of financial derivatives were explained: types of financial derivatives (forwards, futures, options, and swaps), the principles of derivative pricing, and the potential applications in portfolio management. In this chapter and the one to follow, we discuss how derivatives can be used in equity and bond portfolio management. We provide more information about the contracts and their specifications and then show how they are actually used in practice. In doing so, we demonstrate some of the difficulties of implementing strategies involving derivatives.
17.1 Stock Index Futures and Portfolio Management Applications
In this section we look at how to use stock index futures contracts in portfolios. Before doing so, we discuss the basic features of stock index futures and the theoretical price of a stock index futures contract. In the previous chapter, the basic model for the theoretical price of a futures contract was explained. Our discussion of the pricing of stock index futures contracts in this chapter explains why their price would deviate from the price obtained from the basic model.
17.1.1 Basic Features of Stock Index Futures
The underlying for a stock index futures contract can be a broad-based stock market index or a narrow-based stock market index. Examples of broad-based U.S. stock market indexes that are the underlying for a futures contract are the S&P 500, Nasdaq Composite ...