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Forward and Futures Contracts

Finance Theory

Applications

Index Futures Have Many Advantages

  • Since underlying asset is a portfolio, trading in the futures market is easier than trading in cash market
  • Futures prices may react quicker to macroeconomic news than the  index itself
  • Index futures are very useful for:
    • Hedging market risk in block purchases and underwriting
    • Creating synthetic index fund
    • Portfolio insurance

Example:

You have $1 million to invest in the stock market and you have decided to
invest in the S&P 500. How should you do this?
  • One way is to buy the S&P 500 in the cash market:
    – Buy the 500 stocks, weights proportional to their market caps
  • Another way is to buy S&P futures:
    – Put the money in your margin account
    – Assuming the S&P 500 is at 1,000 now, number of contract to buy: (value of a futures contract is $250 times the S&P 500 index)
    \dfrac{$1,000,000}{250 \times 1,000} = 4

Example (cont):

  • As the S&P index fluctuates, the future value of your portfolio (in $MM) is given by the following table (ignoring interest payments and  dividends):

    S & P 500
    		 Cash Portfolio
    		  Futures Portfolio
    900
    1,000
    1,100
    		 $0.90
    $1.00
    $1.10
    		  $0.90
    $1.00
    $1.10

  • Suppose you a diversified portfolio of large-cap stocks worth $5MM and are now worried about equity markets and would like to reduce  your exposure by 25% - how could you use S&P 500 futures to  implement this hedge?
    – (Short) sell5 S&P 500 futures contracts (why 5?)
  • Compare hedged and unhedgedportfolio (in $MM):

    S & P 500
    		 Cash Portfolio
    		  Cash Plus Futures Portfolio
    900
    1,000
    1,100
    		 $4.50
    $5.00
    $5.50
    		  $4.50 + $0.125= $4.625
    $5.00
    $5.50 - $0.125 = $5.375
  • Fluctuations have been reduced
  • As if 25% of the portfolio has been shifted to cash