Stock Index Futures Underlying Assets (sample)• S&P 500• NYSE Composite Index• Major Market Index (MMI) (CBOE)• Value Line Index
Why Are They Traded?1. Arbitrage2. Change position quickly3. Create synthetic fund4. Hedge equity position
Index Mutual Fund Management• Index mutual funds attempt to track the market index• It is difficult to track the Market index because the market
index…• …pays no taxes• …incurs no transaction costs• …does not experience reinvestment risk
Methods used to enhance index mutual fund returns• Index arbitrage
• Index futures are often mispriced (1-3% annually)
• Create low cost surrogate funds with futures• Long index position allows for low cost arbitrage
Index Futures Strategies
Index Arbitrage A profit opportunity from change in the
traditional basis spread between index prices and index futures prices
The basis spread between the index and index futures contract should be constant.
Spreads which are larger or smaller than normal will result in arbitrage opportunities.
Index Arbitrage
Price
0 30 60 90 Time (days)
--- S&P 500 Index
--- S&P 500 Futures Contract
To return to the proper basis spread, the contract will have to drop RELATIVE TO the index.
Strategy:
• Short the contract
• Long the index
Index Arbitrage (another example)
Price
0 30 60 90 Time (days)
--- S&P 500 Index
--- S&P 500 Futures Contract
To return to the proper basis spread, the contract will have to rise RELATIVE TO the index.
Strategy:
• Long the contract
• Short the index
Cash Substitute Strategy If you hold cash equivalents, holding futures
instead, allows upside potential Example: If you hold 95% equity & 5% cash, you
will underperform the market because cash earns less
Also called “Full Investment Strategy”
Futures Strategies
Cash Substitute Strategy - example
Futures Strategies
Price
0 30 60 90 Time (days)
--- 95% stocks 5% cash
--- 100% Stocks
Cash Substitute Strategy – example (continued) Annual returns
◦ Stocks return = 12% ◦ Cash equivalent return = 4%
100% Stock 95% Stock 5% Cash1.00 x .12 = .12 .95 x .12 = .114
.05 x .04 = .002.116
12% vs. 11.6%
Futures Strategies
Substitution Strategies1. Temporary position2. Simulate an equity investment with futures (i.e.
Hedge Fund)3. Accelerate investment process
◦ Similar to “Full Investment Strategy”
Example• You manage a mutual fund• End of year causes influx of cash• Goal - keep cash position at minimum• New year is anticipated to produce large outflows
Futures Strategies
Example – Accelerate Investment Process You manage a $25 million mutual fund Investors send you $3 million in cash, for
which you do not yet have investments selected.
Assume the S&P Index contract is currently valued at 1390.
If your mutual fund has a beta of 1.3 and you wish to immediately be fully invested, what will you do?
Futures Strategies
Example – Accelerate Investment Processcontinued We need to simulate a $3,000,000 investment in our
mutual fund (i.e. a long position)
1 S&P contract = 1390 x 250 = $347,500
Futures Strategies
11.2 contracts = ------------------------ X 1.3 3,000,000
347,500
Example – Accelerate Investment ProcessContinued
11 x 347,500 x .15 = $573,375
ANSWER: To be fully invested you need to simulate a $3,000,000 investment. A deposit of $573,375 into a margin account and going long 11 S&P 500 Index contracts will accomplish this goal.
This strategy will simulate full investment for your mutual fund.
Futures Strategies
Temporary position
The same approach used to “accelerate the investment process” can be used to create a temporary position.
Futures Strategies
Simulate an Investment (Hedge Fund)
The same approach used to “accelerate the investment process” can be used to create a hedge fund.
The difference between a simulated investment and an actual investment is◦ Leverage◦ Length of investment◦ Money required
Futures Strategies
Underwriter Hedging Equity underwriters: commission,
guarantee or purchase. A guarantee or purchase an equity issue
creates price risk Risk exists from date of purchase to sale
date Index contracts can be used to hedge
risk Beta is used as the hedge ratio
Futures Strategies
Underwriter Hedging – EXAMPLE• On September 1 Merrill Lynch (ML) agrees to buy
$10mil of HSE Corporate stock & resell it on Sept 4
• ML estimates a $100/share price• The S&P 500 Index contract is priced @ 1470• 1470 x 250 = $367,500• How can ML hedge its risk if HSE has a beta of
0.8?• What is their profit or loss if on Sept 4, they sell
HSE @ $90 & close their contract on the S&P contract @ 1290?
Futures Strategies
Underwriter Hedging – EXAMPLE - continued• On September 1 Merrill Lynch (ML) agrees to buy $10mil of HSE Corporate stock &
resell it on Sept 4• ML estimates a $100/share price• The S&P 500 Index contract is priced @ 1470• 1470 x 250 = $367,500• How can ML hedge its risk if HSE has a beta of 0.8?• What is their profit or loss if on Sept 4, they sell HSE @ $90 & close their contract on
the S&P contract @ 1290?
Futures Strategies
21.8 contracts = ------------------------ X 0.8 10,000,000
367,500
22 contracts
Underwriter Hedging – EXAMPLE - continued
Futures Strategies
Asset Position Futures PositionStart Long stock Short 22 contracts
100,000 x $100= 1470 x 250 x 22 = $10,000,000 $8,085,000
Price drops to $90 Long 22 contracts @ 1350 100,000 x $90= 1290 x 250 x 22 =
Finish $9,000,000 $7,095,000 . loss $1,000,000 gain $ 990,000
Net position Gain / Loss = - $ 10,000
Futures contracts allow cheap entry & exit from markets
Index contracts can be used to alter portfolio allocation for short periods of time
Use index contracts when large outflows are expected
Futures Strategies
Currency FuturesIdentical to commodity futures in short termStrategy is naive hedge
ExampleOn May 23, a US firm agrees to buy 100,000
motorcycles from Japan on Dec 20 at Y202,350 each. The firm fears a decline in $ value
Spot price = 142.45 (Y/$) or .00720 $/YDec Futures = 139.18 (Y/$) or .00719 $/YEach K is Y12,5000,000
How can we hedge this position
Currency Futuresexample continued100,000 x Y202,350 = Y 20235 mil
20235 mil = 1,619 ks 12.5 mil
You should buy 1619 yen futures to hedge the risk
Currency Futuresexample continued
if $/Y drops to .00650 ($/Y) or 153.846Y/$Cost = $ cost - futures profitcost = 20235 (.0065) - (1619)(12.50)(.00065- .007190)
cost = 131.53 - (-13.96) = $ 145.49 mil
if $/Y rises to .008 ($/Y) or 125 Y/$Cost = $ cost - futures profitcost = 20235 (.008) - (1619)(12.50)(.0080- .007190)
cost = 161.88 - 16.39 = $ 145.49 mil
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