In finance

Finance

"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...

, a stock market index future is a cash-settled futures contract

Futures contract

In finance, a futures contract is a standardized contract between two parties to exchange a specified asset of standardized quantity and quality for a price agreed today with delivery occurring at a specified future date, the delivery date. The contracts are traded on a futures exchange...

 on the value of a particular stock market index

Stock market index

A stock market index is a method of measuring a section of the stock market. Many indices are cited by news or financial services firms and are used as benchmarks, to measure the performance of portfolios such as mutual funds....

.

Market

The turnover for the global market in exchange-traded equity index futures is notionally valued, for 2008, by the Bank for International Settlements

Bank for International Settlements

The Bank for International Settlements is an intergovernmental organization of central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks." It is not accountable to any national government...

 at USD 130 trillion.

Uses

Stock index futures are used for hedging

Hedge (finance)

A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...

, trading

Trader (finance)

A trader is someone in finance who buys and sells financial instruments such as stocks, bonds, commodities and derivatives. A broker who simply fills buy or sell orders is not a trader, as they are merely executing instructions given to them. According to the Wall Street Journal in 2004, a managing...

, and investments.

• Hedging using stock index futures could involve hedging against a portfolio of shares or equity index options.

• Trading using stock index futures could involve, for instance, volatility trading (The greater the volatility, the greater the likelihood of profit taking
  Profit taking
  In finance, profit taking is the practice of selling an asset, mostly shares, when the asset has risen in price. This allows investors to convert the increase of an asset's market value into cash....
  
   – usually taking relatively small but regular profits).

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

Please note the following cases of equity hedging with index futures:

• Where your portfolio 'exactly' reflects the index (this is unlikely). Here, your portfolio is perfectly hedged via the index future.
• Where your portfolio does not entirely reflect the index (this is more likely to be the case). Here, the degree of correlation between the underlying asset and the hedge is not high. So, your portfolio is unlikely to be 'fully hedged'.

Equity index futures and index options

Stock market index option

Stock market index option is a type of option, which is a financial derivative. Index options may be tied to the price of either broad-based indexes like the S&P 500 Index or the Russell 3000 Index or to narrow-based indexes, which is an index that is limited to a particular industry like the...

 tend to be in liquid markets for close to delivery contracts. They trade for cash delivery, usually based on a multiple of the underlying index on which they are defined (for example £10 per index point).

OTC

Over-the-counter (finance)

Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....

 products are usually for longer maturities, and are usually a form of options product. For example, the right but not the obligation to cash delivery based on the difference between the designated strike price, and the value of the designated index at the expiration date. These are traded in the wholesale market, but are often used as the basis of guaranteed equity products, which offer retail buyers a participation if the equity index rises over time, but which provides guaranteed return of capital

Return of capital

Return of capital refers to payments back to "capital owners" that exceed the growth of a business. It should not be confused with return on capital which measures a 'rate of return'....

 if the index falls. Sometimes these products can take the form of exotic option

Exotic option

In finance, an exotic option is a derivative which has features making it more complex than commonly traded products . These products are usually traded over-the-counter , or are embedded in structured notes....

s (for example Asian options or Quanto options).

Pricing

Forward prices of equity indices are calculated by computing the cost of carry of holding a long position in the constituent parts of the index. This will typically be

• The risk-free interest rate
  Risk-free interest rate
  Risk-free interest rate is the theoretical rate of return of an investment with no risk of financial loss. The risk-free rate represents the interest that an investor would expect from an absolutely risk-free investment over a given period of time....
  
  , since the cost of investing in the equity market is the loss of interest
• Minus the estimated dividend yield
  Dividend yield
  The dividend yield or the dividend-price ratio on a company stock is the company's total annual dividend payments divided by its market capitalization, or the dividend per share, divided by the price per share. It is often expressed as a percentage...
  
   on the index, since an equity investor receives the sum of the dividends on the component stocks. Since these occur at different times, and are difficult to predict, estimation of the forward price can be difficult, particularly if there are not many stocks in the chosen index.

Indices for futures are the well-established ones, such as S&P 500

S&P 500

The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...

, FTSE

FTSE 100 Index

The FTSE 100 Index, also called FTSE 100, FTSE, or, informally, the footsie , is a share index of the 100 most highly capitalised UK companies listed on the London Stock Exchange....

, DAX

DAX

The DAX is a blue chip stock market index consisting of the 30 major German companies trading on the Frankfurt Stock Exchange. Prices are taken from the electronic Xetra trading system...

, CAC40 and other G12

Group of Twelve

The Group of Twelve or G12 is a group of industrially advanced countries whose central banks co-operate to regulate international finance....

 country indices. Indices for OTC

Over-the-counter (finance)

Within the derivatives markets, many products are traded through exchanges. An exchange has the benefit of facilitating liquidity and also mitigates all credit risk concerning the default of a member of the exchange. Products traded on the exchange must be well standardised to transparent trading....

products are broadly similar, but offer more flexibility.