A futures contract with a specific stock market index as its underlying asset and which can be settled for cash is a stock index future. These instruments are primarily used for hedging.
Introduced in the early 1980s, stock index futures are largely adopted by institutional investors. These contracts are normally traded in terms of number of contracts where each contract is to purchase or sell a fixed value of the index. The contract value is arrived by multiplying the value of the particular index with a specified amount, which is usually fixed by the exchange on which the contract is traded.
For ex: The value of an S&P 500 futures contract is worked as below:
Say, S&P 500 is quoting at 1,000, and the exchange fixed amount is $ 250. Then the value of the contract amounts to $ 250,000 (1000 *250).
Main purposes of stock index futures can be categorized under three brood ways:
• Hedging – Investors can use stock futures to hedge against a portfolio of equity index options or shares.
• Trading – Volatility trading is usually involved generating regular profits to traders.
• Investing – Investors can make indirect investments into a particular sector without actually purchasing shares of the companies in the said sectors.
Pricing of stock index futures is based on the cost of carry of holding a long position. It constitutes computing risk free interest rate minus the estimated dividend yield on the index. Interest rate is key as it is the opportunity loss for investing in equity indices and dividend yield is considered as investors receive dividends on the stocks. Well established global futures are S&P 500, DAX, FTSE, CAC40.
Normally index futures are settled for cash as they are based on stocks of different companies. The profit or loss on the expiry of the contract is calculated considering the final settlement price as determined by the exchange and relevant adjustments shall be made to the trading account with the amount of profit made or loss incurred.
Stock index futures offer cost effective and efficient way of hedging and investors can make good profits by avoiding unwarranted speculations.