. 143
( 193 .)


Stock index futures

Contract Underlying Market Index Contract Size Exchange

S&P 500 Standard & Poor™s 500 $250 times the S&P 500 Chicago Mercantile Exchange
index. A value-weighted index.
arithmetic average of
500 stocks.
Dow Jones Industrials Price-weighted arithmetic $10 times the Dow Jones Chicago Board of Trade
(DJIA) average of 30 blue-chip Industrial Average.
S&P Midcap Index of 400 firms of $500 times index. Chicago Mercantile Exchange
mid-range market value.
Nasdaq 100 Value-weighted $100 times the OTC Chicago Mercantile Exchange
arithmetic average of 100 index.
of the largest over-the-
counter stocks.
Russell 2000 Index of 2,000 smaller $500 times the index. Chicago Mercantile Exchange
Nikkei Nikkei 225 stock average. $5 times the Nikkei index. Chicago Mercantile Exchange
FT-SE 100 Financial Times-Share £10 times the FT-SE Index. London International
Exchange Index of 100 Financial Futures Exchange
U.K. firms.
CAC 40 Index of 40 of the largest 10 euros times the index. MATIF (March© à Terme
French firms. International de France)
DAX 30 Index of 30 of the largest 25 euros times the index. DTB (Deutsche Terminboerse)
German firms.
DJ Euro STOXX 50 Value-weighted index of 10 euros times the index. Eurex
50 large stocks in
Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

16 Futures Markets

TA B L E 16.3
S&P 1 0.988 0.980 0.992
Correlations among
NYSE 1 0.944 0.994
major U.S.
stock market Nasdaq 1 0.960
indexes DJIA 1

Note: Correlations were computed from monthly percentage rates of price appreciation between 1992 and 1999.

of 1,210, for example, would result in a profit for the long side of $250 (1,210 1,200)
$2,500. The S&P contract by far dominates the market in stock index futures.
The broad-based U.S. stock market indexes are all highly correlated. Table 16.3 presents a
correlation matrix for four U.S. indexes. Even the DJIA, with only 30 stocks, exhibits a cor-
relation above 0.96 with the S&P, Nasdaq, and NYSE indexes. This is testament to the power
of even moderate diversification.

Creating Synthetic Stock Positions
One reason stock index futures are so popular is that they substitute for holdings in the under-
lying stocks themselves. Index futures let investors participate in broad market movements
without actually buying or selling large numbers of stocks.
Because of this, we say futures represent “synthetic” holdings of the market position. In-
stead of holding the market directly, the investor takes a long futures position in the index.
Such a strategy is attractive because the transaction costs involved in establishing and liq-
uidating futures positions are much lower than what would be required to take actual spot
positions. Investors who wish to buy and sell market positions frequently find it much
cheaper and easier to play the futures market. Market timers who speculate on broad mar-
ket moves rather than individual securities are large players in stock index futures for this
One way to market time is to shift between Treasury bills and broad-based stock market
holdings. Timers attempt to shift from bills into the market before market upturns and to shift
back into bills to avoid market downturns, thereby profiting from broad market movements.
Market timing of this sort, however, can result in huge trading costs with the frequent purchase
and sale of many stocks. An attractive alternative is to invest in Treasury bills and hold vary-
ing amounts of market index futures contracts.
The strategy works like this. When timers are bullish, they will establish many long fu-
tures positions that they can liquidate quickly and cheaply when expectations turn bearish.
Rather than shifting back and forth between T-bills and stocks, traders buy and hold T-bills
and adjust only the futures position. (Recall strategies A and B of the preceding section
where we showed that a T-bill plus futures position resulted in a payoff equal to the stock
price.) This strategy minimizes transaction costs. An advantage of this technique for timing
is that investors can implicitly buy or sell the market index in its entirety, whereas market
timing in the spot market would require the simultaneous purchase or sale of all the stocks
in the index. This is technically difficult to coordinate and can lead to slippage in the exe-
cution of a timing strategy.
The nearby box illustrates that it is now commonplace for money managers to use futures
contracts to create synthetic equity positions in stock markets. The article notes that futures
positions can be particularly helpful in establishing synthetic positions in foreign equities,
where trading costs tend to be greater and markets tend to be less liquid.
Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

Got a Bundle to Invest Fast? Think Index Futures
manager succeeds in outperforming the market, but
As investors go increasingly global and market turbu-
still loses 3% while the market as a whole falls 10%.
lence grows, stock-index futures are emerging as the
Hedging with futures would capture that margin of out-
favorite way for nimble money managers to deploy
performance, transforming the loss into a profit of
their funds.
roughly 7%. Demand for such protection helped ac-
What™s the big appeal? Speed, ease, and cheap-
count for stock futures™ surging popularity in last year™s
ness. For most major markets, stock futures not only
difficult markets, Goldman said in its report.
boast greater liquidity but also offer lower transaction
“You can get all the value your managers are going
costs than traditional trading methods.
to add” relative to the market, “and you don™t need to
Portfolio managers stress that in today™s fast-moving
worry about the costs of trading” actual securities, said
markets, it™s critical to implement decisions quickly. For
David Leinweber, director of research at First Quadrant
giant mutual and pension funds eager to keep assets
Corp., a Pasadena, Calif., investment firm that traded
fully invested, shifting billions around through stock-
some $59 billion of futures in 1994.
index futures is much easier than trying to identify indi-
Among First Quadrant™s futures-intensive strategies
vidual stocks to buy and sell.
is “global tactical asset allocation,” which involves trad-
“When I decide it™s time to move into France, Ger-
ing whole markets worldwide as traditional managers
many, or Britain, I don™t necessarily want to wait around
might trade stocks. The growing popularity of such
until I find exactly the right stocks,” says Fabrizio Pier-
asset-allocation strategies has given futures a big boost
allini, manager of New York-based Vontobel Ltd.™s Euro
in recent years.
Pacific Fund.
When it comes to investing overseas, futures are
Mr. Pierallini, who has $120 million invested in
often the only vehicle that makes sense from a cost
stocks in Europe, Asia, and Latin America, says he later
standpoint. Abroad, transaction taxes and sky-high
finetunes his market picks by gradually shifting out of
commissions can wipe out more than 1% of the money
futures into favorite stocks. To the extent Mr. Pierallini™s
deployed on each trade. By contrast, a comparable
stocks outperform the market, futures provide a means
trade in futures costs as little as 0.05%.
to preserve those gains, even while hedging against
market declines.
For instance, by selling futures equal to the value of SOURCE: Suzanne McGee, The Wall Street Journal, February 21,
the underlying portfolio, a manager can almost com- 1995. Reprinted by permission of The Wall Street Journal, © 1995
pletely insulate a portfolio from market moves. Say a Dow Jones & Company, Inc. All Rights Reserved Worldwide.


Hedging by Using Index Futures
The Chicago Mercantile Exchange, along with most of the organized exchanges, offers
significant educational material online. A good introduction to hedging and the use of
futures can be found at the following website: http://www.cme.com/allaire/spectra/system/
securemediastore/G96_Hedge_Portfolio 2002.pdf
After reviewing this short pamphlet, address the following questions:
1. Which index futures contracts trade on the Chicago Mercantile Exchange?
2. What ranges of correlation were reported in this publication between the S&P 500
Index and the returns on selected mutual funds?
3. Review the results and basic plan in strategy A for hedging a long position. If the
market index had risen, what type of results would you have expected? Briefly

Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

16 Futures Markets

Index Arbitrage and the Triple-Witching Hour
Whenever the actual futures price differs from its parity value, there is an opportunity for
profit. This is why the parity relationships are so important. One of the most notable develop-
ments in trading activity has been the advent of index arbitrage, an investment strategy that index arbitrage
exploits divergences between the actual futures price on a stock market index and its theoret- Strategy that exploits
ically correct parity value. divergences between
In principle, index arbitrage is simple. If the futures price is too high, short the futures con- actual futures prices
and their theoretically
tract and buy the stocks in the index. If it is too low, go long in futures and short the stocks.
correct parity values
You can perfectly hedge your position and should earn arbitrage profits equal to the mispric-
to make a riskless
ing of the contract. profit.
In practice, however, index arbitrage can be difficult to implement. The problem lies in
buying the stocks in the index. Selling or purchasing shares in all 500 stocks in the S&P 500
is difficult for two reasons. The first is transaction costs, which may outweigh any profits to
be made from the arbitrage. Second, it is extremely difficult to buy or sell the stock of 500 dif-
ferent firms simultaneously”and any lags in the execution of such a strategy can destroy the
effectiveness of a plan to exploit short-lived price discrepancies.
Arbitrageurs need to trade an entire portfolio of stocks quickly and simultaneously if they
hope to exploit temporary disparities between the futures price and its corresponding stock in-
dex. For this they need a coordinated trading program; hence the term program trading, program trading
which refers to coordinated purchases or sales of entire portfolios of stocks. Such strategies Coordinated buy
can be executed using the NYSE SuperDot (designated order turnaround) system, which en- orders and sell orders
ables traders to send coordinated buy or sell programs to the floor of the stock exchange over of entire portfolios,
usually with the aid of
computer lines. (We discussed the SuperDot system in Chapter 3.)
computers, often to
In each year, there are four maturing S&P 500 futures contracts. On these four Fridays,
achieve index
which occur simultaneously with the expiration of S&P index options and options on some in- arbitrage objectives.
dividual stocks, the market has tended to exhibit above-average volatility. These dates have
been dubbed the triple-witching hour because of the occasional volatility associated with the triple-witching
expirations in the three types of contracts. hour
The program trading associated with index arbitrage commonly accounts for 10“20% of
The four times a year
NYSE daily volume. The Wall Street Journal regularly reports on program trading, both in ag-
that the S&P 500
gregate and for the largest traders. futures contract
expires at the same
time as the S&P 100
Foreign Exchange Futures index option contract
and option contracts
Exchange rates between currencies vary continually and often substantially. This variability on individual stocks.
can be a source of concern for anyone involved in international business. A U.S. exporter who
sells goods in England, for example, will be paid in British pounds, and the dollar value of
those pounds depends on the exchange rate at the time payment is made. Until that date, the
U.S. exporter is exposed to foreign exchange rate risk. This risk can be hedged through cur-
rency futures or forward markets. For example, if you know you will receive £100,000 in 60
days, you can sell those pounds forward today in the forward market and lock in an exchange
rate equal to today™s forward price.
The forward market in foreign exchange is relatively informal. It is simply a network of
banks and brokers that allows customers to enter forward contracts to purchase or sell cur-
rency in the future at a currently agreed-upon rate of exchange. The bank market in currencies
is among the largest in the world, and most large traders with sufficient creditworthiness exe-
cute their trades here rather than in futures markets. Contracts in these markets are not stan-
dardized in a formal market setting. Instead, each is negotiated separately. Moreover, there is
Bodie’Kane’Marcus: V. Derivative Markets 16. Futures Markets © The McGraw’Hill
Essentials of Investments, Companies, 2003
Fifth Edition

588 Part FIVE Derivative Markets

no marking to market as would occur in futures markets. Forward contracts call for execution
only at the maturity date.
For currency futures, however, there are formal markets established by the Chicago Mer-
cantile Exchange (International Monetary Market), the London International Financial Futures
Exchange, and other exchanges. Here, contracts are standardized by size, and daily marking
to market is observed. Moreover, there are standard clearing arrangements that allow traders
to enter or reverse positions easily.
Figure 16.6 reproduces a Wall Street Journal listing of foreign exchange spot and forward
rates. The listing gives the number of U.S. dollars required to purchase a unit of foreign cur-
rency and then the amount of foreign currency needed to purchase $1.
The forward quotations in Figure 16.6 always apply to rolling delivery in 30, 90, or 180
days. Thus, tomorrow™s forward listings will apply to a maturity date one day later than to-
day™s listing. In contrast, foreign exchange futures contracts mature at specified dates in
March, June, September, and December (see Figure 16.2); these four maturity days are the


. 143
( 193 .)