STOCK INDEX FUTURES



A contract for stock index futures is based on the level of a particular stock index such as the S&P 500 or the Dow Jones Industrial Average. The agreement calls for the contract to be bought or sold at a designated time in the future. Just as hedgers and speculators buy and sell futures contracts and options based on a future price of corn, foreign currency, or lumber, they may—for mostly the same reasons—buy and sell contracts based on the level of a number of stock indexes.

Stock index futures may be used to either speculate on the equity market's general performance or to hedge a stock portfolio against a decline in value. It is not unheard of for the expiration dates of these contracts to be as much as two or more years in the future, but like commodity futures contracts most expire within one year. Unlike commodity futures, however, stock index futures are not based on tangible goods, thus all settlements are in cash. Because settlements are in cash, investors usually have to meet liquidity or income requirements to show that they have money to cover their potential losses.

VALUING STOCK INDEX FUTURES

All stock index futures contracts have a value equal to their price multiplied by a specified dollar amount. To illustrate, the price of a stock index futures contract based on the New York Stock Exchange (NYSE) Composite Index is derived by multiplying the index level value by $500. This value results because each futures contract is equal to $500 times the quoted futures price. So, if the index level is determined to be 200, the corresponding stock index future would cost $100,000. The index level is marked-to-market, meaning that at the end of each day its value is adjusted to reflect changes in the day's share prices.

In stock index futures contracts, there are two parties directly involved. One party (the short position) must deliver to a second party (the long position) an amount of cash equaling the contract's dollar multiplier multiplied by the difference between the spot price of a stock market index underlying the contract on the day of settlement ( IP spot ) and the contract price on the date that the contract was entered ( CP 0 ).

If an investor sells a six-month NYSE Composite futures contract (with a multiplier of $500 per index point) at 444 and, six, months later, the NYSE Composite Index closes at 445, the short party will receive $500 in cash from the long party.

Similarly, if an investor shorts a one-year futures contract at 442 and the index is 447 on the settlement day one year later (assuming that the multiplier is at $500), the short seller has to pay the long holder $2,500.

Thus, positive differences are paid by the seller and received by the buyer. Negative differences are paid by the buyer and received by the seller.

BUYING AND SELLING STOCK INDEX
FUTURES

When an investor opens a futures position, he or she does not pay the entire amount of the equity underlying the futures contract. The investor is required to put up only a small percentage of the value of the contract as a margin. A margin is the amount of money required for investors to give to their brokers to maintain their futures contracts. Unlike margins paid for stock purchases, margins paid for stock index futures are not purchases or sales of actual securities. Instead, they represent agreements to pay or receive the difference in price between the index underlying the contract on the day of settlement (IP spot ) and the contract price on the date that the contract was entered (CP 0 ). The exact amount of money needed to cover the margin is determined by two formulas. Both formulas are a function of the market price, the price of the index, and the strike price. The amount of money required for the margin is the greater result of the two formulas.

If the index moves against the sellers, they will be required to add to the margin amount. Known as a maintenance or variation margin, it is the minimum level to which investors' account equity can fall before they receive a margin call. When investors' equity in a stock index futures account falls below the maintenance level, they receive a margin call for enough money to bring the account up to the initial margin level. This margin requirement mandates that holders of futures positions settle their realized and unrealized profits and losses in cash on a daily basis. These profits and losses are derived by comparing the trade price against the daily settlement price of the futures contract. The settlement price is broadcast by the exchanges soon after the markets close; it represents the pricing of the last 30 seconds of the day's trading.

USES OF STOCK INDEX FUTURES

Investors can use stock index futures to perform myriad tasks. Some common uses are: to speculate on changes in specific markets (see above examples); to change the weightings of portfolios; to separate market timing from market selection decisions; and to take part in index arbitrage, whereby the investors seek to gain profits whenever a futures contract is trading out of line with the fair price of the securities underlying it.

Investors commonly use stock index futures to change the weightings or risk exposures of their investment portfolios. A good example of this are investors who hold equities from two or more countries. Suppose these investors have portfolios invested in 60 percent U.S. equities and 40 percent Japanese equities and want to increase their systematic risk to the U.S. market and reduce these risks to the Japanese market. They can do this by buying U.S. stock index futures contracts in the indexes underlying their holdings and selling Japanese contracts (in the Nikkei Index).

Stock index futures also allow investors to separate market timing from market selection decisions. For instance, investors may want to take advantage of perceived immediate increases in an equity market but are not certain which securities to buy; they can do this by purchasing stock index futures. If the futures contracts are bought and the present value of the money used to buy them is invested in risk-free securities, investors will have a risk exposure equal to that of the market. Similarly, investors can adjust their portfolio holdings at a more leisurely pace. For example, assume the investors see that they have several undesirable stocks but do not know what holdings to buy to replace them. They can sell the unwanted stocks and, at the same time, buy stock index futures to keep their exposure to the market. They can later sell the futures contracts when they have decided which specific stocks they want to purchase.

Investors can also make money from stock index futures through index arbitrage, also referred to as program trading. Basically, arbitrage is the purchase of a security or commodity in one market and the simultaneous sale of an equal product in another market to profit from pricing differences. Investors taking part in stock index arbitrage seek to gain profits whenever a futures contract is trading out of line with the fair price of the securities underlying it. Thus, if a stock index futures contract is trading above its fair value, investors could buy a basket of about 100 stocks composing the index in the correct proportion—such as a mutual fund comprised of stocks represented in the index—and then sell the expensively priced futures contract. Once the contract expires, the equities could then be sold and a net profit would result. While the investors can keep their arbitrage position until the futures contract expires, they are not required to. If the futures contract seems to be returning to fair market value before the expiration date, it may be prudent for the investors to sell early.

USING INDEXES TO HEDGE PORTFOLIO
RISK

Aside from the above uses of indexes, investors often use stock index futures to hedge the value of their portfolios. To implement a hedge, the instruments in the cash and futures markets should have similar price movements. Also, the amount of money invested in the cash and futures markets should be the same. Toillustrate, while investors owning well-diversified investment portfolios are generally shielded from unsystematic risk (risk specific to particular firms), they are fully exposed to systematic risk (risk relating to overall market fluctuations). A cost-effective way for investors to reduce the exposure to systematic risk is to hedge with stock index futures, similar to the way that people hedge commodity holdings using commodity futures. Investors often use short hedges when they are in a long position in a stock portfolio and believe that there will be a temporary downturn in the overall stock market. Hedging transfers the price risk of owning the stock from a person unwilling to accept systematic risks to someone willing to take the risk.

To carry out a short hedge, the hedger sells a futures contract; thus, the short hedge is also called a "sell-hedge." For example, consider investors who own portfolios of securities valued at $1.2 million with a dividend of 4 percent. The investors have been very successful with their stock picks. Therefore, while their portfolios' returns move up and down with the market, they consistently outperform the market by 6 percent. Thus, the portfolio would have a beta of 1.00 and an alpha of 6 percent. Say that the investors believe that the market is going to have a 15 percent decline, which would be offset by the 1 percent received from dividends. The net broad market return would be -14 percent but, since they consistently outperform the market by 6 percent, their estimated return would be -8 percent. In this instance, the investors would like to cut their beta in half without necessarily cutting their alpha in half. They can achieve this by selling stock index futures. In this scenario, the S&P 500 index is at 240. The contract multiplier is $500, and therefore each contract represents a value of $120,000. Since the investors want to simulate the sale of half of their $1.2 million portfolios, they must sell five contracts (5 × $120,000 = $600,000). Thus, their portfolios would be affected by only half of the market fluctuation. While the investors could protect their portfolios equally well by selling half of their shares of stock and buying them again a short time later, using a short hedge on stock index futures is much cheaper than paying the capital gains tax plus the broker commissions associated with buying and selling huge blocks of stock.

At the extreme, stock index futures can theoretically eliminate the effects of the broad market on a portfolio. Perfect hedges are very unusual because of the existence of basis risk. The basis is the difference between the existing price in the futures market and the cash price of the underlying securities. Basis risk occurs when changes in the economy and the financial situation have different impacts on the cash and futures markets.

TRANSACTION COSTS

Whenever investors trade securities, they must pay transaction costs. Clearly, there is an explicit commission that investors must give their brokers for executing and clearing their trades. While investors can negotiate the commissions paid for stock index futures transactions with their broker, generally, they will pay their brokers around $25 per contract. (This commission varies somewhat with the investors' trading volume and the type of support they receive.) The commission usually covers the opening and the liquidation of the contracts and is paid at the time of their liquidation.

One of the largest attractions that trading stock index futures has is the relatively small transaction costs associated with them, especially when compared with other ways of attaining the same investment goals. For instance, the commissions paid to brokers for stock index futures transactions are much cheaper than the commissions paid for trading an equally large dollar amount of stocks underlying the index. Often, each futures contracts often represents more than $100,000 in stocks, and the associated commission would amount to about $25. For stocks, the commission paid on each share of stock would be about five cents. This could amount to hundreds of dollars commission depending on price per share.

LIMITS ON PRICE MOVEMENTS

For every contract, the exchange on which it is based establishes a limit on the amount the price can change. For each stock index futures contract the minimum price fluctuation, also called the "tick," is .05. So, a one point move in a futures contract means a gain or loss of one dollar times the dollar multiple of the specific contract, say $500. Therefore, the minimum amount that a price can change is .05 multiplied by the contract's dollar multiple, or .05 times $500, which is $25.

POPULAR STOCK INDEXES

Three of the most popular stock index for futures contracts are: The New York Stock Exchange Composite Index (traded on the New York Futures Exchange), the Value Line Composite Index (traded on the Kansas City Board of Trade), and the Standard & Poor's 500 Index (traded on the Chicago Mercantile Exchange). Furthermore, investors can also purchase options on stock index futures; for instance, the Standard & Poor's 500 Stock Index futures options are traded on the Chicago Mercantile Exchange.

SEE ALSO : Derivative Securities ; Futures/Futures Contracts

[ Kathryn Snavely ,

updated by Michael Knes ]

FURTHER READING:

Barron's Finance and Investment Handbook. 2nd ed. New York: Barron's, 1987.

"Beating the S&P, Using Bonds." Kiplinger's Personal Finance Magazine, July 1997.

Bodie, Zvi, Alex Kane, and Alan J. Marcus. Investments. 4th ed. Boston: Irwin/McGraw-Hill, 1999.

Chicago Mercantile Exchange. "Chicago Mercantile Exchange: Getting Started." Chicago: Chicago Mercantile Exchange, 1998. Available from www.cme.com/market/mercwork.html .

Derack, Arthur. Trade the OEX. 3rd ed. Chicago: Bonus Books, 1996.

Fabozzi, Frank J., and Gregory M. Kipnis. Stock Index Futures. Homewood, IL: Dow Jones-Irwin, 1984.

Luskin, Donald L. Index Options and Futures: A Complete Guide. New York: Wiley, 1987.

Millers, John. Stock Index Options and Futures. London: McGraw-Hill, 1992.

Reilly, Frank K., and Keith C. Brown. Investment Analysis and Portfolio Management. 5th ed. Fort Worth, TX: Dryden Press, 1997.

——. Investments. 2nd ed. New York: Dresden Press, 1986.

Ritter, Jay R. "How I Helped Make Fischer Black Wealthier." Financial Management 25, no. 4 (winter 1996).

Weiner, Neil S. Stock Index Futures: A Guide for Traders, Investors, and Analysts. New York: Wiley, 1984.

Wilmott, Paul. Derivatives: The Theory and Practice of Financial Engineering. New York: John Wiley & Sons, Inc., 1998.



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