Stock Index Futures

Stock Index futureis an index derivative that draws its value from an underlying stock index like Nifty or Sensex.

They were first pioneered by the Kansas City Board of Trade on 24th February 1982 and the contract is based on Value Line Composite Index.

Stock Index futures are futures on stock market indices such as the Standard & Poor’s 500 in the US or Nifty in India.

Because it is very inconvenient to deliver the index, stock index futures contracts are settled by a cash amount which is equal to the difference between the contracted, futures price and the final index value times a multiplier that scales the contract size.

Stock Index futures are built on any market index. The underlying instrument is the index point movement.

Stock index and future movements are matched by compensatory cash flows. Futures contracts are available on many stock indices.

In India, the BSE Sensex and S&P Nifty are the popular indices on which there are futures trading.

As a speculation tool, stock index futures represent an inexpensive and highly liquid short-run alternative to speculating on the stock market.

Stock index futures can be used to hedge the risk in a well-diversified portfolio of stocks. Index future is an index derivative that draws its value from an underlying stock index like Nifty or Sensex.

For example, BSE may launch a futures contract on “BSE Sensitive Index” and NSE may launch a futures contract on “S&P CNX NIFTY”.

Index futures are used to manage the systemic risk, vested in the investment in securities.

Features of Stock Index Futures

Index futures have a number of features which are as follows:

1. Leverage: A relatively small performance deposit (initial margin) provides access to substantial equity exposure.

For example, if the cash S&P 500 index is trading at 1200 then each of the major futures contracts is economically equivalent to a market portfolio of shares worth 1200 x $250 = $3,00,000.

If an investor has $3,00,000 to invest, a percentage can be used to make the deposit on the futures and the rest can be kept in a safe money market deposit account.

2. Transaction Costs: These are normally lower when compared to buying and selling underlying shares.

Brokerage charges on futures are low, there is no need for custodians, and (in the U.K.) there is no stamp duty to pay to the government.

It is relatively cheap and easy to switch exposures quickly using futures.

3. Diversification: Index futures provide easy access to a diversified portfolio of shares.

4. Liquidity: The major contracts such as the S&P 500 futures are very actively traded and there are many market participants.

Market access is easy and prices are determined in an open and transparent manner.

It is also just as easy to take a short position as it is to take a long position.

5. Clearing House: Settlement on futures contracts is guaranteed by the clearing house, which virtually eliminates counterparty risk.

6. Basis Risk: The fact that futures prices do not exactly move in line with changes in the price of the underlying cash market day-to-day (the basis is not constant) means that hedging with futures is not an exact science.

It also poses problems for fund managers who are using futures to track an index.

7. Roll-Over Risk: Index futures do not last forever. When a contract expires a trader who wishes to retain the position will have to ‘roll’ ) into the next delivery month.

This contract may be trading cheap or dear relative to fair value.

8. Margin Calls: The margin system helps to protect the stability of the exchange and to ensure that the clearing house can always meet its obligations.

However, it does mean that a trader is subject to margin calls, and may be forced to sell securities quickly to make a payment.

9. Standardized Contracts: In order to make index futures contracts as actively traded as possible they have to be standardized.

This may not suit an investor who, e.g., would like to take an exposure to a subset of shares in an index or to smaller companies.

Uses of Stock Index Futures

Some specific uses of index futures are as follows:

1. Portfolio Restructuring: An act of increasing or decreasing the equity exposure of a portfolio, quickly, with the help of index futures.

2. Index Funds: These are the funds that imitate/replicate index with an objective to generate the return equivalent to the index. This is called Passive Investment Strategy.

3. Hedging: Hedging is a phenomenon through which one can ensure that the losses from stock market investments are low when the market declines.

4. Trading: Trading using stock index futures could involve, e.g., volatility trading (the greater the volatility the greater the likelihood of profit-taking – usually taking relatively small but regular profits).

5. Investing: Investing via the use of stock index futures could involve exposure to a market or sector without having to actually purchase shares directly.

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