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Stock Index Futures: - Organization of Slides
Stock Index Futures: - Organization of Slides
History
Futures Contract Specifications
Risk Management
Index Calculations (Appear in the Extra Section).
By 1986, the S&P 500 futures contract had become the second
most actively traded futures contract in the world, with over 19.5
million contracts traded in that year.
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.
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?
Honeywell
IBM
Intel
International Paper
Johnson & Johnson
McDonalds
Merck
Microsoft
3-M
J.P. Morgan Chase
Philip Morris
Procter & Gamble
SBC Communications
United Technologies
Wal-Mart
Thus, if the DJIA futures price rises one tick, i.e., from 10813 to
10814, a trader who is long one contract profits by $10 because
the value of the stock underlying the contract rises from
$108,130 to $108,140.
David Dubofsky and 8-10
Thomas W. Miller, Jr.
March
June
September
December
David Dubofsky and 8-13
Thomas W. Miller, Jr.
Marking to Market
b)
c)
d)
When they are bullish, i.e., they believe that the stock market
offers a relatively high expected return for a given level of risk,
they will increase the beta of their stock portfolio.
When they are bearish, (or simply believe that the risk of the
market has increased), they will decrease their portfolio's beta.
N=
- P
F
Portfolio Value
(Futures Price) Multiplier
The manager does not wish to incur the commission costs and
price pressure of selling stocks and then repurchasing them
after the anticipated decline.
N=
0.0 - 1.20
1
$20,000,000
= -75.
(1280) 250
The Key: Set the target portfolio beta, d, 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.
SPH: 1,243.50
S&P Index: 1,239.40
T-bill rate: 4.35%
Days to Expiration: 42
Annual Dividend Yield: 1.32% (assume this is the
dividend yield in terms of its future value)
What is the theoretical futures price, and the Deviation
from Fair Value (DFV)?
David Dubofsky and 8-26
Thomas W. Miller, Jr.
The DOT
Little did the designers of DOT realize that their system would
be adopted by index arbitrageurs, who now enter orders to buy
or sell portfolios of stocks, including the composition of any
index replicating portfolio (e.g., 1000 shares of IBM, 1267
shares of GM, etc.).
David Dubofsky and 8-30
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.
Even with Super DOT, there are some risks to index arbitrage.
Large orders to trade securities are not guaranteed any price,
and prices can change quickly in the few minutes that it takes to
execute all of the desired trades.
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Price
Am. Express
28.625
485.445
13,895.9
0.0560
1,956
GE
105.250
852.935
89,771.4
0.3618
3,437
3M
103.250
215.791
22,280.4
0.0898
870
Merck
32.125 1,282.316
41,194.4
0.1660
5,167
Exxon
65.250 1,241.618
81,015.6
0.3265
5,003
248,157.7 1.0000
16,434
Total: 334.500
Total:
Price
Price Price-Weighted
Weight
Shares
28.625
0.086
2,990
GE
105.250
0.315
2,990
3M
103.250
0.309
2,990
Merck
32.125
0.096
2,990
Exxon
65.250
0.195
2,990
334.500
1.000
2,990
The divisor is printed in the Wall Street Journal every day and is
also available in the equity product information area at
http://www.cbot.com.
For example, on April 24, 2001, the divisor for the DJIA was
0.15369402. On September 9, 1999, the divisor was
0.19740463.
Company
Am. Express
GE
3M
Merck
Exxon
Sum:
Index:
Price
28.625
105.250
103.250
32.125
65.250
334.500
66.90 (Divisor = 5)
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.
Price
Equal Equal-Weighted
Weight
Shares
28.625
0.200
6,987
GE
105.250
0.200
1,900
3M
103.250
0.200
1,937
Merck
32.125
0.200
6,226
Exxon
65.250
0.200
3,065
1.000
20,115
The levels of these and yet other indices are presented daily in
the Wall Street Journal. While each index is a different portfolio
of stocks, the method of computing each index is the same.
David Dubofsky and 8-43
Thomas W. Miller, Jr.
Day 2:
Company
Price
Am. Express 28.625
GE
105.250
3M
103.250
Merck
32.125
Exxon
65.250
Total Shares
Market Capitalization
(millions)
(millions)
485.445
13,896
852.935
89,771
215.791
22,280
1,282.316
41,194
1,241.618
81,016
Total MV(1):
248,158
248.1576686
1000.00
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
Company
Am. Express
GE
3M
Merck
Exxon
Price
25.000
108.500
93.700
37.875
62.000
Total Shares
Market Capitalization
(millions)
(millions)
485.445
12,136.1
852.935
92,543.4
215.791
20,219.6
1,282.316
48,567.7
1,241.618
76,980.3
Total MV(3):
250,447.2
1009.23
Day 2 Index
Day 2 Index