Uses
Stock index
futures are used for hedging, trading, investments.
- Hedging
using stock index futures could involve hedging against a
portfolio of shares or equity index options.
- Trading
using stock index futures could involve, for instance, volatility
trading (The greater the volatility the greater the likelihood
of profit taking usually taking relatively small but regular
profits.
- Investing
via the use of stock index futures could involve exposure
to a market or sector without having to actually purchase
shares directly.
Please note
the following cases of equity hedging with index futures:
- Where
your portfolio 'exactly' reflects the index (this is unlikely).
Here, your portfolio is perfectly hedged via the index future.
- Where
your portfolio does not entirely reflect the index (this is
more likely to be the case). Here, the degree of correlation
between the underlying asset and the hedge is not high. So,
your portfolio is unlikely to be 'fully hedged'.
Equity index
futures and options tend to be in liquid markets for close to delivery
contracts. They trade for cash delivery, usually based on a
multiple of the underlying index on which they are defined (for
example £10 per index point).
OTC products
are usually for longer maturities, and are usually a form of
options product. For example, the right but not the obligation
to cash delivery based on the difference between the designated
strike price, and the value of the designated index at the expiration
date. These are traded in the wholesale market, but are
often used as the basis of guaranteed equity products, which
offer retail buyers a participation if the equity index rises
over time, but which provides guaranteed return of capital if
the index falls. Sometimes these products can take the form
of exotic options (for example Asian options or Quanto options).
Pricing
Forward
prices of equity indices are calculated by computing the cost
of carry of holding a long position in the consitutuent parts
of the index. This will typically be
- The risk-free
interest rate, since the cost of investing in the equity market
is the loss of interest
- Minus
the imputed dividend yield on the index, since an equity investor
receives the sum of the dividends on the component stocks.
Since these occur at different times, and are difficult to
predict, estimation of the forward price is something of an
art, particularly if there are not many stocks in the chosen
index.
Indices
for futures are the well-established ones, such as S&P, FTSE, DAX, CAC40 and other G12 country indices. Indices
for OTC products are broadly similar, but offer more flexibility.