Stock Index Future

Application

"How do derivative products relate to the cash market? My answer is that they relate like two doors into the same room." - Merton Miller.

Derivative markets have won the role of pricing Equity away from the traditional stock exchanges. This has happened not only in the United States, but in the many other countries that have established index derivative markets in recent years, including Singapore.

The term equity derivative products means so many different things these days that I cannot hope to cover all or even a representative sample of them. Instead, I will focus on just the exchange-traded index futures.

To see why and how institutional investors use index futures, imagine you are the manager of an insurance company, or a large portfolio, a pension fund, perhaps, or a bank trust fund. You know that over longtime horizons, the returns on well-diversified portfolios of Equities tend to exceed those of alternative investments like corporate or government bonds. You know also, however, that your cash outflows for pensions or medical benefits or other guranteed returns to the beneficiaries may sometime exceed your cash inflows. Since stocks do well in the long run and in the average year but not necessarily in every year, when the shortfall is unexpectedly large you may have to liquidate a portion of your portfolio. If that forced liquidation comes at a time when the stock market is depressed, the damage to your clients' interests can be substantial. So you try to protect against this danger by holding government and coporate bonds in your portfolio as well as stock. The long run return on those bonds will be less than on your stocks, but so will be their year-to year variation in market value.

A portfolio that includes both stocks and bonds, so called balanced portflio, has thus become the standard strategy for pension funds and trust funds. As to how much you should put into bonds, Modern Portfolio Thoery can offer you no firm guidance. The fixed-income proportion is what portfolio managers get paid to choose, and it will depend on how they view the risk-return tradeoff, or, as the old saying has it, whether you and your clients prefer to eat well or sleep well.

A typical split might be, say 60% stocks and 40% bonds. If you are like most portfolio managers, you would not fix those proportions once and for all time. For any good number of reasons, at some point in time you might feel that 60% was just too much equity exposure. At that point you might feel that 50% equity and 50% Debt would be a safer mix for the fund and its beneficiaries. You reserve always the right to restore the old balance or even increase the equity share in the future if conditions or market prospects change.

It's precisely at this point in the decision cycle, when you are reconsidering your equity exposure, that you should think about index futures.

Use of derivative as hedging

Let's say you want to cut your equity exposure by $20m and transfer it to your fixed income portfolio. You can do so in two ways. One way is to sell $20m of the stocks in your equity portfolio. Then take the cash to the bond markets and buy some appropriate short-term fixed-income instrument such as Treasury bills. That is certainly a way that is familiar and easy to understand. But it can be slow, even in this day of the Superdot and program trading. And it can also be expensive.

There is another way of doing exactly the same thing. Suppose instead that you simply sell $20m of MSCI Singapore Stock Index Futures contracts. That one transaction, which can be accomplished in a couple of minutes, or even seconds, is exactly equivalent to the 2-step procedure of first selling the separate stocks and then buying bills.

How can one simple transaction do so much? When you sell the $20m of futures contracts, you have eliminated any risk in $20m of the stocks. Let me note that although I speak loosely of selling a future contract, you don't actually sell anything. You simply take a position in a futures contract by agreeing to pay money to or collect money from the exchange's clearinghouse, depending on how the index happens to move over the duration of your futures contract. If you take a short position in futures, which is the functional equivalent of short selling in the cash market, and if the index rises, you must pay the clearinghouse for the loss on your futures position. But that loss will be offset exactly by the gain you make on the underlying stocks which you continue to hold. And vice versa if the index falls, you will gain on your futures and lose on your stock. Because you are thus completely protected, or hedged, against price moves in either direction, your $20m of stocks has effectively been converted into a riskless asset,like Treasury Bills.

To illustrate my point, look at the following example:

SIMEX MSCI Singapore Stock Index Futures - Contract Specifications:

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