Page 179 - DMGT513_DERIVATIVES_AND_RISK_MANAGEMENT

Derivatives & Risk Management

Notes If we assume that the S&P 500 is quoting at 1,000, the value of one contract will be equal to
$250,000 (250 × 1,000). The monetary value $250 in this case is fixed by the exchange where the
contract is traded.

Advantages of using Stock Index Futures

The various advantages of using stock index futures are:
1. Actual purchases are not involved: Stock index futures permit investment in the stock
market without the trouble and expense involved in buying the shares themselves.

2. There is high leverage due to margin system: Operating under a margin system, stock index
allows for full participation in market moves without significant commitment of capital.
The margin levels may allow leverage of up to 30-40 times.
3. Lower transaction costs: The transaction costs are typically many times lower than those
for share transactions.
4. Hedging of share portfolio: Portfolio managers for large share portfolios can hedge the
value of their investment against bear moves without having to sell the shares themselves.

Thus, the changing nature of the future market has meant new types of market participants.
Today, the largest and most prestigious financial institutions like banks, pension funds, insurance
companies, mutual funds all around the world use futures and futures markets have become an
integral part of how these institutions manage their risks and portfolio of assets.

Pricing of Index Future Contracts

Unlike an options contract, pricing of a futures contract is easy to understand. The price of the
stock index futures is given as:
FB = IB + (Rf – D),
where
FB = Current futures price

IB = Current index price
Rf = Risk free rate of interest
D = Dividends

(Rf – D) above indicates the cost of carrying an index in future. Thus, if the annualised risk free
rate of interest is 13% and the annualised dividend yield is 6%, a futures contract on the index for
one year should sell at an annualised 7% (13 – 6) premium to index, independent of expectations
for the market.

Self Assessment

Fill in the blanks:
1. Index options offer the investor an opportunity to either capitalize on an expected market
move or to protect holdings in the ………….. instruments.
2. In India, index options have a ………… style settlement.
3. A stock index futures contract is a contract to buy or sell the ……………..of the underlying
stock index.

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