CHAPTER 9

Security Futures Products Introduction

Chapter 9 and 10 explore stock index futures. This chapter

is organized into the following sections:

1. Indexes

2. Stock Index Futures Contracts

3. Stock Index Futures Prices

4. Index Arbitrage and Program Trading

5. Speculating with Stock Index Futures

6. Risk Management with Stock Index futures

Chapter 9 1
 Indexes

If you have insight into the future direction of the stock

market, specifically one index or another, you may want to
trade stock index futures.

Stock index futures allow you to make a bet on which

direction you think a stock market index is headed.

Stock index futures also allow you to hedge various

financial positions.

Stock index futures trade on a number of different indexes.

Chapter 9 2
 Indexes

IN D E X

D ow Jones
The various indexes use differing computational methods.
To understand the trading and pricing of index futures, one
must first understand a bit about how the underlying
indexes are computed.

Chapter 9 3
 Priced-Weighted Indexes

In a price-weighted index, stocks with a higher price

receive a larger weighting in the computations.

Price-weighted indexes do not consider dividends paid by

the stocks.

The companies contained in these indexes change

infrequently. Changes only occur as a result of special
events like liquidations and mergers.

In this section, the DJIA is used as a representative price-

weighted index. The DJIA is comprised of 30 stocks. Table
9.1 shows the lists of stocks.

Chapter 9 4
DJIA Index

Alcoa
Altria G
Americ
Chapter 9 5
 Priced-Weighted Indexes

The DJIA is computed by adding the share prices of the 30

stocks comprising the index and dividing by the DJIA
divisor. The divisor is used to adjust for stock splits,
mergers, stock dividends, and changes in the stocks
included in the index.

Index Divisor

The index divisor is a computed number that keeps the

index unchanged in the event of certain occurrences (e.g.,
dropping one company from the index and adding another
company, mergers and stock splits).

The DJIA can be computed by using the following formula:

∑
N
Pi
Index = i =1
Divisor

where:
Pi = price of stock i

Chapter 9 6
 Priced-Weighted Indexes

Assume that the Dow Jones company decides to delete

Boeing from the index and replace it with Dow Chemical.
Boeing stock trades at $6.00 and Dow Chemical trades at
$47. The current level of the index is 1900.31 with a divisor
of .889.
Before the Change
Total 30 stock prices = $1,689.375

∑
N
Pi
Index = i =1

Divisor
1,689.375
Index = = 1900.31
0.889
After the Change (No New Divisor Is Used)

Total new 30 stock price: $1,689.375 - 6+47 = $1,730.375

1,730.375
Index = = 1946.43
0.889

Chapter 9 7
 Priced-Weighted Indexes

If the divisor is not changed the DJIA will be 46 points

higher as a result of the component change. Thus, a
new divisor must be calculated.
A new divisor is computed as follows:

New Sum of Prices

New Divisor =
Index Value Before Substituti on

The new divisor is given by:

1,730.375
New Divisor = = 0.9106
1900.31

Thus, to keep the index value unchanged, the new

divisor must be 0.9106.

Chapter 9 8
Market Capitalization-Weighted Indexes

Each of the stocks in these indexes has a different weight

in the calculation of the index. The weight is proportional to
the total market value of the stock (the price per share
times the number of shares outstanding).

The value of the S&P 500 index is reported relative to the

average value during the period of 1941-1943, which was
assigned an index value of 10.

Assume that the S&P 500 index consists of three stocks

ABC, DEF and GHI.

Table 9.2 shows how the value of these 3 firms will be

weighted.

Chapter 9 9
 Market Capitalization-Weighted Indexes

The S&P index is calculated as:

 500 
 ∑ N i , t Pi , t 
 i=1  10
S & P Index t =  
O.V.
 
 

where:
O.V. = original valuation in 1941-43
Ni,t
Pi,t
= number of shares outstanding for firm i
= price of shares in firm i Compan
Chapter 9

Compan
10
 Total Return Indexes

Similar to the Market Capitalization Indexes, these indexes

reflect the total change in the value of the portfolio from
inception to the current date.

= M t − base value
Indext
Bt
Where
Mt = market capitalization of the index at
time t
Bt = adjusted base date market
capitalization of the index at time t
base value = the original numerical starting value for
the index (e. g.,100 or 1000)

Chapter 9 11
 Total Return Indexes

From the above equation, the numerator reflects the total

accumulated value of the portfolio and the denominator
represents the initial value of the portfolio. As such, both
the numerator and denominator are affected by several
factors as follows:

Affected by Numerator Denominator

Price of share Yes

No. of shares Yes
Exchange rate Yes
Dividends Yes
Splits Yes
Mergers Yes
Repurchase Yes
Mergers Yes
Spin-offs Yes

Chapter 9 12
 Stock Index Futures Contracts

Index futures are available on a number of different indexes.

Table 9.3 provides a summary of the features of the most
important futures contracts.

Contract

DJIA
As Table 9.3 shows, the total value of a futures
position depends on the currency, the multiplier, and
the level of the index.
Chapter 9 13
 Stock Index Futures Contracts

The contract size is computed by multiplying the level of

the index by the appropriate multiplier.

Example

Assume that The DJIA is 11,000 and the multiplier for the
DJIA futures contract is 10. What is the value of a given
contract?

The futures product has a contract value of:

11,000 X $10 or $110,000

Now, assume that DJIA goes up to 11,250. What is the

value of a given contract?

The futures product has a contract value of:

$10 X 10,250 = $112,500

One point change in the DJIA results in a $10 change in

the value of the futures contract.

Notice that price changes for a contract depend on the

contract size and volatility of the index.

Chapter 9 14
E-Mini S&P 500 Futures

P
C o n tr a c t
Chapter 9 15
E-Mini NASDAQ 100 Futures

Pr
C o n tr a c t
D e liv e r a b
Chapter 9 16
Dow Jones Euro STOXX Futures

P rodu
C o n tr a c t S
D e liv e r a b le
Chapter 9 17
 Price Quotation Stock Index Futures

Insert Figure 9.1 here

Chapter 9 18
 Stock Index Futures Prices

Stock index futures trade in a full-carry market. As such,

the Cost-of-Carry Model provides a good understanding of
index futures pricing.

Recall that the Cost-of-Carry Model for a perfect market

with unrestricted short selling is given by:

F 0, t = S 0(1 + C 0, t )

Applying this model to stock index futures has one

complication, dividends.

If you purchase the stocks in the index, you will receive

dividends. Recall that most indexes ignore dividends in
their computation, so the Cost-of-Carry Model must be
adjusted to reflect the dividends.

The receipt of dividends reduces the cost of carrying the

stocks from today until the delivery date on the futures
contract.

Chapter 9 19
 Stock Index Futures Prices

Today, t0, a trader decides to engage in a self-financing

cash-and-carry transaction. The trader decides to buy and
hold one share of Widget, Inc., currently trading for $100.
The trader borrows $100 to buy the stock. The stock will
pay a $2 dividend in 6 months and the trader will invest the
proceeds for the remaining 6 months at a rate of 10%.
Table 9.4 shows the trader's cash flows.

The trader's cash inflow after one year is the future

value of the dividend, $2.10, plus the value of the stock

t= 0
in one year, P1, less the repayment of the loan, $110.

Chapter 9 20
 Stock Index Futures Prices

From the above example, we can generalize to understand

the total cash inflows from a cash-and-carry strategy.

1. The cash-and-carry strategy will return the future value

of the stock, P1, at the horizon of the carrying period.

2. At the end of the carrying period, the cash-and-carry

strategy will return the future value of the dividends.
– the dividend plus interest from the time of receipt to
the horizon.

1. Against these inflows, the cash-and-carry trader must

pay the financing cost for the stock purchase.

Chapter 9 21
 Stock Index Futures Prices

In order to adjust the Cost-of-Carry Model for dividends,

the future value of the dividends that will be received is
computed at the time the futures contract expires. This
amount is then subtracted from the cost of carrying the
stocks forward.
N
F 0, t = S 0(1 + C 0, t ) − ∑ Di (1 + ri )
i =1

Where:
S0 = The current spot price
F0,t = The current futures price for delivery of the
product at time t
C0,t = The percentage cost of carrying the stock
index from today until time t
Di = The ith dividend
ri = The interest earned from investing the
dividend from the time received until the
futures expiration at time t

Chapter 9 22
 Fair Value for Stock Index Futures

A stock index futures price has a fair value when the

futures price conforms to the Cost-of-Carry Model.

In this section, we use a simplified example to determine

the fair value of a stock index futures contract. Assume a
futures contract on a price-weighted index, and that there
are only two stocks. Table 9.5 provides the information
needed to compute the stock index fair value.

Today's date Chapter 9 23

 Fair Value for Stock Index Futures

Step 1: compute the current fair value for stock index

futures.
The value of the index is given by:

∑
N
Pi
i =1
Index =
Divisor

$115 + 84
Index =
1.8
Index = 110.56

Step 2: determine the cost of buying the stocks.

Cost Stock A + Cost of Stock B = $115+84 = $199

Chapter 9 24
 Fair Value for Stock Index Futures

Step 3: compute the future value of the dividends for each

stock.

Stock A: PV = 1.50, N = 59, I = 10/360, FV = ? = $1.52

Stock A: PV = 1.00, N = 39, I = 10/360, FV = ? = $1.01
Total Future Value of Dividends $2.53

Step 4: compute the cost of carry.

We will store the stocks for 76 days at 10% annual interest.

The interest for 76 days will be:

76
Co , t = 0.10 X
360
Co , t = 0.0211

Chapter 9 25
 Fair Value for Stock Index Futures

Step 5: solve for the futures price as follows:

N
F 0, t = S 0(1 + C 0, t ) − ∑ Di (1 + ri )
i =1

F 0, t = 199(1 + 0.0211) − 2.53

F 0, t = 203.20 − 2.53
F 0, t = 200.67

The cost of buying the stocks and carrying them to the

future is $200.67.
Step 6: compute the fair price of the index. To compute
the fair value for the index, we must convert the
previous answer into index units.
F 0, t
Fair Value of Index =
Divisor
$200.67
Fair Value of Index =
1.8
Fair Value of Index = 111.48

Notice that the fair value of the index (111.48) is different

than the current level of the index (110.56). This difference
suggests that possibility of an arbitrage.

Chapter 9 26
 Index Arbitrage and Program Trading

Index arbitrages refer to cash-and-carry strategies in stock

index futures. This section examines:
–Index arbitrage

–Program trading

Recall that deviations from the theoretical price of the Cost-

of-Carry Model give rise to arbitrage opportunities.

If the futures price exceeds its fair value, traders will engage
in cash-and-carry arbitrage.

A cash-and-carry arbitrage involves purchasing all the

stocks in the index and selling the futures contract.

If the futures price falls below its fair value, traders can
exploit the pricing discrepancy through a reverse cash-and-
carry strategy.

A reserve cash-and-carry arbitrage involves selling the

stocks in the index short and buying a futures contract.

We would expect the futures prices to follow those

suggested by the Cost-of-Carry Model. To the extent that
they do not, traders can engage in index arbitrage.

Chapter 9 27
 Index Arbitrage

To demonstrate how index arbitrage works, we will examine

a two-stock index. The Information on the index futures and
the two stocks contained in the index are presented in
Table 9.5.

Today's da Chapter 9 28
 Index Arbitrage

Using the previous calculations:

The cash market index value is 110.56.

Fair price for the futures contract is 111.48.

Rule #1

If the futures price exceeds the fair value, cash-and-carry

arbitrage is possible.

Rule #2

If the futures price is below the fair value, reverse cash-

and-carry arbitrage is possible.

Table 9.6 and 9.7 show the cash-and-carry and reserve

cash-and-carry index arbitrage respectively.

Chapter 9 29
 Index Arbitrage

Suppose the data from Table 9.5 holds, but the futures
price is $115 which is above the fair value. The
transactions for a cash-and-carry arbitrage are presented
in Table 9.6.

Date
J uly 6
Chapter 9 30
 Index Arbitrage

Now suppose that all the information from Table 9.5 holds,
but the futures price is $105, which is below the fair value of
$111.48, so a reverse cash-and-carry arbitrage is possible.
Table 9.7 shows the transactions for a reverse cash-and-
carry arbitrage.

Date
J uly 6 Chapter 9 31
 Program Trading

When performing index arbitrage, the investor must buy or

sell all of the stocks in the index.
For example, to perform index arbitrage on the S&P 500
index, one would need to purchase or sell 500 different
stocks.
Because of the difficulty in doing this, the trading is
frequently done by computer. This is called program
trading.
The computer will download the prices of all 500 stocks,
compute the fair price of the index and compare that to the
price of the futures contract.
If a cash-and-carry arbitrage is suggested, the computer
will initiate trades to purchase all 500 stocks. It will also
sell the futures contract.
Because of the number of stocks involved, performing a
successful index arbitrage involves very large sums of
money and very rapid trading. As such, institutional
investors (mutual funds and the like) are the ones that
typically engage in index arbitrage.

Chapter 9 32
 Predicting Dividends Payments and
Investment Rates

Dividend Amount and Timing

So far we have assumed certainty with regard to dividend
amount, timing and investment rates.
In the real market, dividends are predictable, but are not
certain.
To the extent that they are not predicted with certainty, the
cash-and-carry index arbitrage can be frustrated.
For the DJIA with 30 stocks, dividends are relatively stable.
Thus prediction can be moderately accurate.
For the SEP 500 or NYSE Indexes, many smaller
companies are involved and dividend prediction becomes
much less certain.
Moreover, dividends are paid in seasonal patterns as
shown in Figure 9.2.
Predicting the Investment Rate
Predicting the investment rate for dividends can be done
with some certainty, as it is a relatively short term
investment that will occur in the near future.

Chapter 9 33
 Distribution of Dividend Payments

Insert Figure 9.2 here

Chapter 9 34
 Market Imperfections and Stock Index
Futures Prices

Recall that four market imperfections could affect the

pricing of futures contracts:

1. Direct Transaction Costs

2. Unequal Borrowing and Lending Rates

3. Margins

4. Restrictions on Short Selling

Market imperfections exist and can be substantial,

particularly for indexes with large numbers of stocks.

The existence of market imperfections leads to no-

arbitrage bounds on index arbitrage.

So the price has to get out of sync by a good bit to cover

the transaction costs and other market imperfections
associated with attempting the arbitrage.

Chapter 9 35
 Speculating with Stock Index Futures

Futures contracts allow speculators to make the most

straightforward speculation on the direction of the market
or to enter very sophisticated spread transactions to tailor
the futures position to more precise opinions about the
direction of stock prices.

The low transaction costs in the futures market make the

speculation much easier to undertake than similar
speculation in the stock market itself.

Tables 9.8 and 9.9 illustrate two cases of stock index

futures speculation, a conservative inter-commodity spread
and a conservative intra-commodity spread.

Chapter 9 36
 Speculating with Stock Index Futures

A trader observe that the DJIA futures is 8603.50 and

the S&P 500 futures is 999. The trader expects the
DJIA to go up more rapidly than the S&P 500 index due
to market conditions. To bet on her intuition the trader
enters into an inter-commodity spread as indicated in
Table 9.8.

Date
The spread has widened as expected and thus, the
trader was able to realize a $16,447.50 profit.

Chapter 9 37
 Speculating with Stock Index Futures

In the event that a trader expects more distant contracts

to be more sensitive to a market move than the nearby
contracts. The trader initiates a intra-commodity spread
as shown in Table 9.9.

In this case, the position is so conservative that there

Date
was little difference in the price changes, producing only
a $112.50 profit, despite the fact that the market moved
in the predicted direction.

Chapter 9 38
 Single Stock Futures

Single stock futures contracts are written on shares of

common stocks.

Currently worldwide, 20 exchanges trade single stock

futures or have announced their intention to do so.

In 2002, NQLX and OneChicago, started trading single

stock futures.

NQLX, based in New York, is a joint venture of:

Nasdaq
London International Financial Futures Exchange

OneChicago, based in Chicago, is a joint venture of:

CBOE
CBOT
CME

Chapter 9 39
 Single Stock Futures

Single stock futures contracts specify:

The identity of the underlying security

Delivery procedures
The contract size (100 shares)
Margin
The trading environment
The minimum price fluctuation
Daily price limits
The expiration cycle
Trading hours
Position limits

They contain provisions for adjustments to reflect certain

corporate events (e.g., stock splits and special dividends).

They expire on the 3rd Friday of the delivery month.

Chapter 9 40
 Single Stock Futures

Single stock futures are priced using the Cost-of-Carry

Model.

Example

Today, Feb 20, the current price of Wal-Mart stock is

$59.45/share. The JUN futures contract for Wal-Mart will
expires on June 18. Wal-Mart’s quarterly dividend is
expected to be 9 cents/share on April 7. The current
financing cost is assumed to be 1.6% per year.

Since there is only a single dividend payment during the

life of the futures contract, the cost-of-carry relationship
becomes simple:

F0,t = 59.45 *(1 + .016*119/365) - .09(1 + .016*72/119)

F0,t = $59.45 + .31 - .09

F0,t = $59.67/ share.

Chapter 9 41
Risk Management with Security Futures
Contracts: Short Hedging

Hedging with stock index futures applies directly to the

management of stock portfolios. This section examines
short and long hedging applications for stock index futures.

Assume that a portfolio manager has a well-diversified

portfolio with the following characteristics:

Portfolio Value = $40,000,000

Portfolio Beta = 1.22 (relative to the S&P 500)

S&P 500 Index = 1060.00

The portfolio manager fears that a bear market is imminent

and wishes to hedge his portfolio's value against that
possibility.

The manager could use the S&P 500 stock index futures
contract. By selling futures, the manager should be able to
offset the effect of the bear market on the portfolio by
generating gains in the futures market.

Chapter 9 42
Risk Management with Security Futures
Contracts: Short Hedging

Assuming that the S&P index futures contract stands at 1060, the advocated futures position would be given by:

VP $40,000,000
− = = −150.94 ≅ −150 contracts
V F (1060)($250)

where:
VP = value of the portfolio
VF = value of the futures contract

This strategy ignores the higher volatility of the stock

portfolio relative to the S&P 500 index.

Table 9.10 illustrates the potential results.

Chapter 9 43
 Risk Management with Security Futures
Contracts: Short Hedging

The manager might be able to avoid this negative result by

weighting the hedge ratio by the beta of the stock portfolio.

The failure to consider the difference in volatility between

the stock portfolio and index futures contract leads to
suboptimal hedging results.

Chapter 9 44
Risk Management with Security Futures
Contracts: Short Hedging

Using the following equation the manager can determine the number of contracts to
trade.

VP
− βP = Number of Contracts
VF

Where:
βP = beta of the portfolio that is being hedged.
Thus, The manager would sell:

$40,000,000
− 1.22 = -185.15
(1060)($250)

Chapter 9 45
 Risk Management with Security Futures
Contracts: Long Hedging
A pension fund manager is convinced an extended bull
market in Japanese equities is about to begin. The current
exchange rate is $1 per ¥140. The manager anticipates
funds for investing to be ¥6 billion ( $42,857,143 ≈
$43,000,000) in 3 months. The pension fund manager
trades as shown in Table 9.11.

The futures profit offsets the additional cost of purchasing

stocks because of an increase in prices.

Chapter 9 46