Stock Index Futures

The Standard & Poor’s 500 (S&P 500) Index

- Based on a portfolio of 500 different stocks.
- The weights of the stocks in the portfolio are proportional to their market capitalizations. This
is a value weighted index

Reasons for using stock index futures contract

- To hedge: A portfolio manager does not want her portfolio to be affected by market risk
(systematic risk). Nevertheless, she feels that the stocks in her portfolio have been chosen well.
She is uncertain about the performance of the market as a whole, but confident that the stocks in
the portfolio will outperform the market. She should choose to hedge by going short a stock index
futures contract.
To avoid transaction cost: A hedger may want to hold a portfolio for a long period of time. But he
wants short-term protection in a highly volatile market. He can avoid transaction cost of selling all
stocks by trading index futures.
To change beta of portfolio: The S&P 500 futures contract has a β of approximately 1. If you buy
or sell the S&P 500 futures contract you will be changing the β of the combined stock – stock index
portfolio. If the β of your stock portfolio was below one, then buying the futures contract will
increase the beta of your portfolio and selling the futures contract will decrease the beta of your
portfolio.

Stock Index Futures Pricing

If you examine the underlying equity market, you realize that the five characteristics required for the
carry market model to be applicable are present. The only modification required is to adjust for the
dividends received if you hold the stock. Dividends received reduce the cost of holding the cash
stock position. These strategies are known as index arbitrage.
Arbitrage with S&P Futures (Picture)

Buy stocks/sell futures is a cash and carry (referred as a buy program). When the
market opens, we are going to try buy stocks and sell futures to arbitrage.

A sell program is referred as reverse cash and carry

Determining Expected Future Dividend Yield

• Given the price of two futures contracts with different maturities on the same Stock Index and the

expected interest rate between the two maturities one can determine the expected forward dividend

yield. This procedure is similar to the process we used to compute the cost of borrowing a

commodity earlier in the course.

When the interest rate is higher than the dividend yield, the market is in contango.
When the IRR is lower than the div yield, the market is in backwardation. In this example, the
market is in backwardation.