Page 178 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Unit 13: Risk Management with Derivatives II

13.1 Index Options and Futures Notes

Index options and futures are discussed as below:

13.1.1 Index Options

Like equity options, index options offer the investor an opportunity to either capitalize on an
expected market move or to protect holdings in the underlying instruments. The difference is
that the underlying instruments are indexes. These indexes can reflect the characteristics of
either the broad equity market as a whole or specific industry sectors within the marketplace. In
the US, stock index options traded on SP100 and NYSE composite index are very popular. SP100
is an index of many individual stocks that pay different dividends throughout the year but the
index itself exhibits discontinuous leakage as most stock dividends are paid out during certain
months/days. These options have the index as the underlying. In India, they have a European
style settlement. Eg. Nifty options, Mini Nifty options etc.

13.1.2 Index Futures

These futures contract without actual delivery were introduced only in 1982 and are the most
recent major futures contract to emerge. In the United States, these contracts trade on several
market indices like Standard and Poor's 500, a major market index, the NYSE Index and the
Value Line Index. Numerous contracts on industry indices are now trading as well.
A stock index futures contract is a contract to buy or sell the face value of the underlying stock
index where the face value is defined as being the value of index multiplied by the specified
monetary amount.
This device makes it possible to equate the value of the stock index with that of a specific basket
of shares with the following specifications.
1. The total value of shares must match the monetary value of the index.
2. The shares selected must correspond to the set of shares used to create the index.

3. The amount of each holding must be in proportion to the market capitalisation of the
companies.
The profit or loss from a futures contract that is settled at delivery is the difference between the
value of the index at delivery and the value when originally purchased or sold. It is important
to emphasise that the delivery at settlement cannot be in the underlying stocks but must be in
cash.

!
Caution The futures index at expiration is set equal to the cash index on that day.

Index futures are futures markets where the underlying commodity is a stock index, such as the
Dow Jones, or the FTSE100. Stock indexes cannot be traded directly, so futures based upon stock
indexes are the primary way of trading stock indexes. Index futures are essentially the same as
all other futures markets (currency and commodity futures markets), and are traded in exactly
the same way. Stock index futures are traded in terms of number of contracts. Each contract is to
buy or sell a fixed value of the index. The value of the index is defined as the value of the index
multiplied by the specified monetary amount. In the S&P 500 futures contract traded at the
Chicago Mercantile Exchange (CME), the contract specification states:
1 Contract = $250 × Value of the S&P 500

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