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Organization of Slides:
History Futures Contract Specifications Risk Management Index Calculations (Appear in the Extra Section).
In their short trading history, stock index futures contracts have had a great impact.
Trading in stock index futures has allegedly made the world's stock markets more volatile than ever before. Critics claim that individual investors have been driven out of the equity markets because institutional traders' actions in both the spot and futures markets cause stock values to gyrate with no links to their fundamental values. Many political figures have called for greater regulation, going so far as to favor an outright ban on stock index futures trading. Fortunately, such extreme measures have been avoided.
David Dubofsky and 8-4 Thomas W. Miller, Jr.
Stock index futures have become irreplaceable in the modern world of institutional money management.
Stock Index futures have revolutionized the art and science of equity portfolio management as practiced by:
mutual funds pension plans endowments insurance company other money managers.
2 Important Details
A futures contract on a stock market index represents the right and obligation to buy or to sell a portfolio of stocks characterized by the index.
Stock index futures are cash settled.
That is, there is no delivery of the underlying stocks. The contracts are marked to market daily. On the last trading day, the futures price is set equal to the spot index level and there is a final mark to market cash flow.
What is an Index?
An index is, in one sense, just a number that is computed in order to measure the value of a portfolio of stocks.
Other indices have been constructed to track the values of other types of securities, such as bonds and futures. Still other indices track such economic indicators as the consumer price index (CPI) or the index of leading indicators.
When constructing a stock market index, three issues are of particular interest:
which stocks are in the index how each stock is weighted how the average is computed
Marking to Market
The smallest allowed price change (the tick) is 0.10 point, which equals $25. Thus, if the S&P 500 futures price falls from 1,019.40 to 1,019.30, the face value of the futures contract declines $25. That is: (1,019.40)(250) = $254,850 (1,019.30)(250) = $254,825 This one tick decrease in the futures price creates a mark to market profit of $25 for an individual who is short one contract.
b)
c)
Stock index futures are also surrogates for the stock purchases when the portfolio manager:
a) has received an inflow of cash but has not decided which stocks or market sectors in which to invest. has a growing bullishness about the market. wants to get market exposure in advance of a near-term expected cash inflow.
b) c)
d)
If investors are relatively more risk averse or are bearish about the prospects for the stock market, investors will lower the beta of their portfolio by shifting a portion of their assets into risk-less securities. If investors are not very risk averse or if they are bullish about the market, investors will raise their portfolio's beta by borrowing additional capital and investing the borrowed funds in risky securities.
David Dubofsky and 8-17 Thomas W. Miller, Jr.
N=
- P F
N=
0.0 - 1.20
1
The Key: Set the target portfolio beta, bd, equal to 0.0. Then, using the equation above, we conclude that the manager should sell 75 futures contracts. Suppose the manager was right about the market's movement, and the S&P 500 declines to 1224, which is a 4% decline in the market.
David Dubofsky and 8-21 Thomas W. Miller, Jr.
Arbitrage Bounds
In practice, if F > S + CC - CR, then arbitrageurs' purchases of stock increase stock prices (these are called buy programs). Their sales of futures will depress futures prices, until equilibrium is again reached (F S + CC - CR), and no arbitrage opportunities exist. Similarly, if F < S + CC - CR, the buying of cheap futures and the sale of expensive stock (sell programs).
Their purchases of futures will increase futures prices, until equilibrium is again reached (F S + CC - CR), and no arbitrage opportunities exist.
David Dubofsky and 8-24 Thomas W. Miller, Jr.
Program Trading
Program trading is a technique for trading a stock portfolio in one single order. The NYSE defines a program trade as: "a wide range of portfolio trading strategies involving the purchase or sale of a basket of 15 stocks or more, and valued at more than $1 million". Program trading may involve stock index arbitrage, option replication strategies, or asset allocation shifts (such as between equities and bonds), etc. Recent growth in program trading has arisen from brokers who offer institutions the ability to trade large portfolios of stocks with low cost and little price impact. In 2001, program trading accounted for almost 30% of total NYSE volume.
David Dubofsky and 8-25 Thomas W. Miller, Jr.
Let TC1 and TC2 = transaction costs (commissions, etc.) necessary to perform reverse cash and carry arbitrage, and cash and carry arbitrage, respectively. Sbid (1+hl(0,T)) - div(1+hb(,T)) - TC1 < F < Sask(1+hb(0,T)) - div(1+hl(,T)) + TC2
David Dubofsky and 8-28 Thomas W. Miller, Jr.
The DOT
In 1976, the New York Stock Exchange introduced its Designated Order Turnaround (DOT) system, which was improved and renamed Super DOT in November 1984. Super DOT is a computerized order handling system that guarantees that any market order of less than 2100 shares of a stock will be executed within three minutes at the prevailing bid price (for a market sell order) or asked price (for a market buy order) at the time the order was entered, or at better prices if possible. Today, the average order through SuperDot is transmitted, executed and reported back to the originating firm in 22 seconds.
David Dubofsky and 8-29 Thomas W. Miller, Jr.
Computerized Trading
Whenever an arbitrage opportunity arises a trader can literally push a button to submit these orders to buy (at the asked) or sell (at the bid) the entire basket of stocks. On average, the execution of the trade is reported back to the buyer or seller in 22 seconds. At the same time, the arbitrageur will trade the necessary stock index futures contracts. Larger orders (more than 2099 shares of one stock) are handled less efficiently, with trades occurring only after an arbitrageur's human representative carries the order to the specialists' posts.
David Dubofsky and 8-31 Thomas W. Miller, Jr.
Similarly, program selling will often lead to price declines in the spot stock market.
Total: 334.500
248,157.7 1.0000
So, anytime there is a change in the portfolio of the constituent stocks, or if there are splits, stock dividends, or mergers, the DJIA divisor will change because Dow Jones and Company wants to remove the impact on the index from these events. NB: The DJIA is not adjusted to account for regular dividend payments.
David Dubofsky and 8-39 Thomas W. Miller, Jr.
Before Day 2 starts, we want to replace Merck with Intel, selling at $22. To Keep the value of the Index the same, i.e., 66.90: Am. Express GE 3M Intel Exxon Sum: Sum / Divisor = 66.90 if Divisor is: 28.625 105.250 103.250 22.000 65.250 324.375 4.848654709
David Dubofsky and 8-40 Thomas W. Miller, Jr.
Day 2:
Company Price Am. Express 29.000 GE 110.000 3M 92.000 Merck 37.000 Exxon 67.000
Total Shares Market Capitalization (millions) (millions) 485.445 14,078 852.935 93,823 215.791 19,853 1,282.316 47,446 1,241.618 83,188 Total MV(2): 258,388 Day 2 Index Level: 1041.22
Day 2 Index
Market Value Day 2 Index Lev elDay 1 Market Value Day 1 Market Value Day 2 Index Lev elDay 0 Market Value Day 0
Day 2 Index