Index Futures

Stock market indexes are meant to capture the overall

behavior of equity markets
A stock market index is created by selecting a group of stocks
that are representative of the whole market or a specified
sector or segment of the market
A stock index is based on the value of the individual shares
included in the portfolio comprising the index. For example,
the BSE 30 Sensex index in the BSE is made up of 30 stocks
that are traded on the BSE. The S&P CNX Nifty index in the
NSE includes 50 stocks that are traded on the NSE
The index value tracks the movement of the market as a
whole and changes in the value of a portfolio of stocks
Typically, the weight of a stock in the portfolio is equal to the
proportion of the portfolio invested in the stock
The change in the value of a stock index indicates the change
in the value of all stocks included in the portfolio
An index is calculated with reference to a base period and a
base index value and in general, stock indexes are not
adjusted for cash dividends
Stock index futures were one of the earliest financial futures
introduced, and the first contracts started trading in 1982
Stock index futures are futures contracts in which the
underlying asset is the index on which the futures are based
The traders actually bet on what the value of the index
would be at a future time
In the case of stock index futures, the following must be
specified:
The index on which the futures are to be created
The contract size: The contract size is specified as a multiplier
Mode of settlement: Typically, the mode of settlement in
index futures is cash because indexes are not traded in the
market and, therefore, physical delivery is not possible
The price of index futures is always quoted in terms of the
index points and not in terms of currency
The value of a futures contract is then calculated in terms of
currency by multiplying the futures price quoted in points by
the contract size
Gains/losses from long futures = (Futures price at the time
contract is closed out – Futures price at the time contract is
entered into) × Contract size
Gains/losses from short futures = (Futures price at the time
contract is entered into – Futures price at the time contract is
closed out) × Contract size
Question: On September 3, BSE Sensex 30 is at 16,140. BSE
Sensex 30 futures with expiry on October 27 are available at
a price of 16,311. The contract multiplier is 15. Calculate the
cash flow for the following if the BSE Sensex 30 has a value of
16,660 if,
You take a long position in five BSE Sensex 30 futures contracts on
September 3
You take a short position in three BSE Sensex 30 futures contracts
on September 3
 Pricing of Index Futures
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Question: On April 1, the BSE Teck index is at 3,140. You
want to estimate the value of a June futures contract
expiring on June 30. The risk-free rate is 6%. The average
dividend yield on the Teck stocks is 1.6%. What will be the
June futures price on April 1?
Additional Reading
 Speculation Using Index Futures
If you believe that the market is going to do very well (or
poorly) in the near future, you can use this information to
make speculative profits through index futures
If you believe that the market would do better so that the
index value would increase by the expiry date of the futures,
you would take a long position in the index futures
If your belief is that the market would fare poorly so that the
index value would decrease by the maturity date, you would
take a short position in index futures
Question: Suppose the S&P CNX Nifty index value is 4,958
points on April 17, and you believe that the market will do
very well in the near future. The June index futures contract
is trading at 4,990, and the contract multiplier is 50.
How would you speculate using futures?
On April 25, the market has moved up such that the index
value is 5,012 and the futures price is 5,017.6, and you
decide to close the position. What would be your profit?
Question: Suppose that the Nifty Midcap 50 index value is
6,200 on September 22, and you believe that the market is
likely to fare badly in the near future. The December index
futures contract is trading at 6,280, and the contract
multiplier is 300.
How would you speculate using futures?
On September 28, the market has moved down such that the
index value is 5,850 and the futures price is 5,884.20, and
you decide to close the position. What would be your profit?
 Index Arbitrage
If the index futures price deviates from the theoretical value,
there will be arbitrage opportunity. This arbitrage procedure
is known as index arbitrage
If the market price, F *, is greater than this theoretical price
F, or if F* > F, the futures are relatively overpriced with
respect to the index value
If the market price, F*, is lower than the theoretical price F,
or if F* < F, the index value is relatively overpriced with
respect to the futures
If the market price F* is higher than the theoretical price F, or
when the futures are relatively overpriced, arbitrage requires
that the arbitrager sell the futures contracts and buy stocks
in the index
If the market price F* is lower than the theoretical price F, or
when the futures are relatively underpriced, arbitrage
requires that the arbitragers buy the futures contracts and
sell stocks in the index
Due to transaction costs, buying and selling of stocks in the
index is costly. In practice, this is often accomplished by
trading a small representative group of stocks that closely
tracks the movement of the index
Suppose that the Nifty Midcap 50 index value is 6,200 on
September 22, and the December index futures contract
with expiry on December 29 is trading at 6,260. The contract
multiplier is 300, and the risk-free rate is 8%. The dividend
yield on the index is 1.8%.
How would you arbitrage?
On December 29, the market has moved down, and the
index value is 5,850. What would be your arbitrage profit?