K.Cuthbertson and D.

Nitzsche
1
Lecture

Stock Index Futures
Version 1/9/2001
FINANCIAL ENGINEERING:
DERIVATIVES AND RISK MANAGEMENT
(J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche

K.Cuthbertson and D.Nitzsche
2
Topics
Basic Concepts

Speculation

Hedging

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Basic Concepts

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Stock Index Futures:Terminology
Hold, TVS
0
= $2m in diversified equity portfolio
and stock index S
0
= 200

Number of index units in stocks,N
s
=TVS
0
/S
0
=10,000
shares

ie. For each unit change in the index S, then the value
of the stock portfolio changes by $10,000 (DOLLARS)

A(TVS)
t
= N
s
AS
t



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F
0
= 202
z = contract size
= $500 per index point - for S&P 500

Then the face value of one futures contract is
FVF
0
= z F
0
= $500 ( 202 ) = $101,000

Fear a fall in equity prices : what do I do to
hedge ?
Short the futures
How many futures contract do I short ?
Stock Index Futures:Terminology
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Specualtion

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Figure 3.2 : Speculation: Nikkei index (Leeson)
12000
14000
16000
18000
20000
22000
24000
03/01/94 03/07/94 03/01/95 03/07/95 03/01/96 03/07/96
Leeson buys
Leeson closes out / sells
Five eights make $1.4bn ?
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Hedging
with
Stock Index Futures
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Minimum Variance Hedge Ratios
AV
= change in spot market position + change in futures position
= N
s
.(S
1
-S
0
) + N
f
(F
1
- F
0
) z
= N
s
. AS + N
f
(AF) z

where, z= contract multiple ($500 for S&P 500)
AS = S
1
- S
0
,
AF = F
1
- F
0
The variance of the hedged portfolio is
F S
z
f
N
s
N
F
z
f
N
S s
N
V A A
+
A
+
A
=
,
. 2
2 2
) . (
2
)
2
(
2
o o o o
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Minimum Variance Hedge Ratio(1)
|
|
.
|

\
|
=
=
0 t at index spot of Value
Position Spot of Value
A
= | .
.
0
0
S z
TVS
N
f
A
|
|
A
is the regression beta for the absolute change
in your portfolio price S regressed on the
absolute change in F:
ie. |
A
= o(AS, AF)/

o
2
(AF) = o(AS)/

o(AF)

Choose N
f
to minimize variance, gives:
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Minimum Variance Hedge Ratio-(2)
|
|
.
|

\
|
=
=
0
.
t at futures of FaceValue
Position Spot of Value
p f
FVF
TVS
N | .
0
0
=
p
|
|
p
is the regression beta for the percentage change in
your portfolio S (ie. the portfolio return) regressed on the
percentage change in F. In practice hedging error arises
because |
p
is an estimate and may not hold over the
future.
Equivalent expression
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End of Slides