Page 124 - DMGT549_INTERNATIONAL_FINANCIAL_MANAGEMENT

Unit 8: Currency Futures and Currency Options

This device makes it possible to equate the value of the stock index with that of a specific basket Notes
of shares with the following specifications:

The total value of shares must match the monetary value of the index.
The shares selected must correspond to the set of shares used to create the index.
The amount of each holding must be in proportion to the market capitalisation of the
companies.

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Caution 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 emphasize that the delivery at settlement cannot be in the underlying
stocks but must be in cash. The futures index at expiration is set equal to the cash index on
that day.

8.1.2 Pricing of Stock Index Futures

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.

Advantages of Using Stock Index Futures

The various advantages of using stock index futures are:
(i) 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.

(ii) 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.

(iii) Lower Transaction Costs: The transaction costs are typically many times lower than those
for share transactions.
(iv) 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 futures 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.

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