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Chapter 4 Stock Index Futures Contracts; Analysis And Applications

Chapter 4 Stock Index Futures Contracts; Analysis And Applications. Chapter Objective:

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Chapter 4 Stock Index Futures Contracts; Analysis And Applications

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  1. Chapter 4 Stock Index Futures Contracts; Analysis And Applications

  2. Chapter Objective: This chapter examines indepth Stock Index Futures Contracts with specific emphasis on the KLCI futures contracts. The chapter describes how these contracts could be used for hedging, arbitrage and speculative purposes. The newly introduced Single Stock Futures (SSF) contracts are also examined. On completing this chapter, you should have a good understanding of SIF and SSF contracts and its applications.

  3. Introduction • The Kuala Lumpur Composite Index Futures Contract which is a Stock Index Futures (SIF) contract, began trading on 15th December, 1995. Designated as FKLI, the contract was designed and introduced by the Kuala Lumpur Option and Financial Futures Exchange • A Stock Index Futures (SIF) contract is an exchange traded futures contract which has as its underlying asset a basket of common stocks. The basket of common stocks would together make up an Index

  4. all SIF contracts are cash settled, the long position receives a cash settlement instead of a group of stocks. • SIF contracts are cash settled. With cash settlement, the problems associated with physical delivery of the stocks that make up the index is overcome. • E.g. the Dow Jones is an index made up of 30 stocks traded on the NYSE. The KLCI, the Kuala Lumpur Composite Index is an index of 100 stocks traded on the KLSE, while the Nikkei is an index of 225 stocks listed on the first-board of the Tokyo Stock Exchange.

  5. The most popular SIF contracts worldwide • NSIF (Nikkei Stock Index Futures) • S & P 500 (Index of 500 U.S. stocks) • KOSPI Futures (Korea Stock Price Index) • FTSE 100 (index of 100 British stocks) • Valueline Index (U.S. stocks) • TOPIX (Index of 1,000 Japanese stocks) • Hang Seng Index (Index of 30 HK stocks) • MMI - Major Mkt. Index (20 US stocks; 17 from Dow)

  6. Why Use SIF Contracts • Diversification Benefits Diversification benefits refer to reduction in risk as one diversifies across assets. Investment in a SIF contract as opposed to direct investment in stocks provides instant diversification. • Lower Transaction Cost • First, brokerage costs like commissions are lower on a percentage of face value basis. Second, the margins that need to be posted for SIF contracts are also much lower relative to full payment on stock purchase.

  7. Provides Leverage margins in SIF transactions would mean investment outlays that are much lower than transactions in the stock market, implies that there would be automatic leverage with SIF contracts • Market Exposure and Stock Selection Since an Index is representative of the underlying market, a position in SIF contracts allows for exposure to the entire market. That is exposure to broad based market movements

  8. Hedging, Portfolio Insurance and Risk Management Perhaps one of the most useful aspects of SIF contracts is their use in hedging. There are two ways in which SIF contracts are particularly suited for hedging purposes: managing systematic risk and hedging overall portfolio value • Managing Systematic Risk Example, suppose a fund manager has a fully diversified portfolio of RM10 million of stocks. How can he use SIF contracts to reduce the systematic risk? Answer: By taking a short position in SIF contracts

  9. Hedging the overall value of a portfolio As with other futures contracts, SIF contracts are used extensively in managing risk. In the context of equity investment, SIF contracts provide a very effective, easy and low cost method by which equity exposure could be hedged Index Construction and Types of Indexes • An equally weighted (price weighted) Index • A value weighted (capitalization weighted) Index • A Geometrically weighted Index

  10. An Equally Weighted Index In an Equally Weighted Index all component stocks have equal weight. The size of the firm is not adjusted for. Examples : Dow Jones Industrial Average (DJIA), Major Market Index (MMI) and Nikkei 225 Where, Pi = closing price of each component stock. Divisor = statistical adjustment factor for capitalization changes; stock splits, bonus issues, rights, and stock substitution

  11. Capitalization Weighted Index • A Capitalization Weighted index accounts for differences in firm size by weighting for relative market capitalization of component stocks • in a capitalization weighted index each component stock has a different weight in the calculation • The weight of each stock will depend on its market value proportionate to the market value of the total index Examples : S&P 500, TOPIX, KLCI

  12. Where; • N i,t = number of stocks outstanding for firm i on day t. • P i,t = price per share of firm i on day t. • O.V = original value that is, the index value on the day the index computation was begun. • M = an arbitrarily set multiplier usually 100

  13. Example of ComputationSuppose there are 3 stocks in the Index and computation begins on day t = 1

  14. Geometrically Weighted Index Where; Pi t = price per share of firm i on day t Pit – 1 = price ………….. on day t – 1

  15. KLCI Futures, Contract Specifications • Contract Specifications are basically the ground rules by which a derivative contract’s trading is dictated. • The objective of a contract specification is to lay out in clear and uncertain terms the features and trading rules of the contract. • This ensures fairness to all parties involved and a clear and transparent process in settlement, margining etc Table 4.1 below shows the contract specifications for the KLCI futures contract extracted from Bursa Malaysia’s website (See page 60)

  16. The value of each futures contract is 1,000 pts x RM100 = RM100,000 Cost per long position = RM60 • Transaction Cost as % of Value (RM60/RM100,000) X 100 = 0.06% • A RM100,000 position established in the futures market has a transaction cost of RM60 or 0.06 percent

  17. SIF Trading – The Main Players • The main players in SIF markets are institutional investors. This is largely due to the fact that the money amounts involved in SIF trading is large • Since the SIF has a multiplier, in the case of KLCI futures contracts, the multiplier is RM50. This means that a single contract would be worth in excess of RM50,000 if the KL Composite Index is above 1,000 points • The main players would therefore be institutions like Pension Funds, Insurance Companies, Fund Management operations of Merchant Banks, Asset Management companies, Mutual Funds, etc

  18. The Pricing of SIF Contracts Where; Ft,T = the correct price of a SIF contract with maturity t to T So = current value of the underlying index rf = risk free interest rate d = the dividend yield of the underlying index

  19. Using the Cost of Carry ModelAn Example:Assume the following, (a) The Spot Index the KLCI, is now 960 points(b) the average annual dividend yield of the KLCI is 2%(c) the risk free interest rate is 6% annualized(d) index multiplier is RM50What would be the correct price of a SIF contract if it matures in (i) 3 months (ii) 6 months and (iii) 1 year?

  20. 3-Month Maturity Since Multiplier is RM50 = 969.46 points x RM50 Ringgit Value Per Contract = RM48,473.00 1 year Maturity F = 960(1 + .06 - .02)1 = 960 (1.04)1 = 998.40 6-Month Maturity F = 960 (1 + .06 - .02)1/2 = 960 (1.04).5 = 979.01

  21. Dividend Yields and Dividend Payment Patterns(See page 64) Applications of Stock Index Futures Contracts (i) Index Arbitrage • Index Arbitrage is the process of arbitraging mispricing that may exist between the SIF and the stock market • Technically, arbitrage is possible whenever the Futures-Spot parity is violated

  22. IfFt> So (1 + rf-d)T; then the futures is overpriced relative to spot or equivalently, the quoted futures price is higher than what it should be an arbitrageur would; Short the futures contract, and Long the spot market. If Ft < So (1 + rf – d)T; then the futures is underpriced relative to spot or the quoted futures price is lower than what it should be an arbitrageur would; Long the futures contract, and Short the spot market

  23. Example; • Suppose you observe the following quotations today. • 3-month SIF price = 1,210 • Index value = 1,200 pts • rf rate = 4% • Dividend Yield = 2% • Time to maturity of SIF = 90 days • To see if arbitrage is possible we first check for mispricing. The correct value of the 3-month SIF should be; • Ft = 1,200 (1+.04-.02)0.25 = 1,200 (1.02)0.25 = 1,205.96 points

  24. Given the above information, the futures is clearly overpriced relative to spot. The futures price should be 1,205.96 points, yet it is quoted at 1,210 points. Overpriced by approximately 4 points. Since there is mispricing, arbitrage is possible. By using the following arbitrage strategy a riskless profit can be made. (Note that no cash outlay is needed today we will look at 2 market scenarios. (Note: current stock index value is 1,200 pts) • Index Rises to 1225 at maturity • Index Falls to 1175 at maturity

  25. Scenario 1: Index Rises to 1225Cash & Carry Arbitrage

  26. Scenario 2: Index Falls to 1175Cash & Carry Arbitrage

  27. Reverse Cash and Carry ArbitrageSuppose in the above example, the Futures price today is quoted as;3-month SIF price = 1201 Now, the SIF is underpriced relative to spot. In order to arbitrage we need to do the reverse of the earlier strategy The following reverse Cash and Carry arbitrage would be appropriate here

  28. Index Rises to 1225

  29. Index Falls to 1175

  30. Hedging Suppose you are a foreign fund manager with exposure in Malaysian stocks. You intend to keep your position in the stocks since you think the underlying fundamentals are good. However, you are worried about volatility that could erode the current value of your portfolio. Is there anyway by which you could use SIF contracts to protect your portfolio’s value? • Example : • The following information is available to you today, • Current value of Portfolio = RM1,200,000 • rf rate = 6% per year • Div. yield on Portfolio = 2% annualized • Spot Index Value = 1,200 points • 3-month SIF Futures Contract = 1,211.82 points • (Assume the futures will expire in exactly 90 days)

  31. Answer: • Base Hedge = Current Ringgit Value of Portfolio Current Ringgit Value of Index • Base Hedge = RM1,200,000 =20 contracts 1,200 points x RM50 You should short 20 SIF Contracts (if the beta of portfolio is 1.0) Suppose the beta of your portfolio is 1.20 (weighted average of individual stock betas in your portfolio). Base Hedge x Beta of Portfolio 20 x 1.2 = 24 Contracts

  32. Or by the following equation; Number of contracts = Ringgit Value of Portfolio x Beta of Portfolio Ringgit Value of Index = RM1,200,000 x 1.2 1,200 x RM50 = RM1,440,000 =24 Contracts RM60,000

  33. Scenario 1 : The Stock Market falls 20%

  34. Note: • Since beta of portfolio is 1.2; portfolio value falls 24% when market falls 20% • At Maturity; Index Value is 1,200 pts x .80 = 960 pts. SIF value at Maturity = [960 pts x 24] x RM50 • Dividends received over the 90 day period until maturity equals Portfolio value multiplied by the annual dividend yield and divided by 4 to adjust for the 90 day period which is one calendar quarter [RM1,200,000 x 0.02]  4

  35. Scenario 2: The Stock Market Rises 20%

  36. Analysis of Hedged Position Under Scenario 1 • Initial Value of Portfolio = RM1,200,000 • Unhedged Portfolio Value = RM 912,000 • Profit/Loss from SIF Contracts = RM 302,184 • Dividends Received = RM 6,000 • Value of Portfolio with hedge = RM1,220,184 Notice that with hedging your portfolio has grown by RM20,184 over the 90-day period even though the market fell 20%

  37. Under Scenario 2 • Initial Value of Portfolio = RM1,200,000 • Unhedged Portfolio Value = RM 1,488,000 • Profit/Loss from SIF Contracts = (RM 273,816) • Dividends Received = RM 6,000 • Value of Portfolio with hedge = RM1,220,184 With hedging your portfolio has grown by RM20,184 over the 90-day period, even though the market went up by 20%.

  38. Note: • Regardless of market movement, your portfolio’s value is the same. This is precisely the point about hedging – i.e., preservation of value • since your portfolio was fully hedged, the return you can expect should approximate the risk free rate of return Thus, the fully hedged annualized return in percentage is: (Note that we have ignored the opportunity cost of margins posted on the SIF position, taking this into consideration will make the returns closer to the risk free return)

  39. Creating Synthetic Position (Replication) • Suppose in the above example, you had liquidated the portfolio of RM1,200,000 and invested the cash in a risk free asset you would have earned an annualized return equal to 6% • Since you also earned approximately the risk free return with the hedged portfolio, you have essentially created a synthetic cash position (or synthetic t-bill position) To summarize the following replication strategies hold Synthetic T-bill Position = Short Futures + Long Stocks Synthetic Stock Position = Long Futures + Long T-bills Synthetic Futures Position = Long T-bills + Short Stock

  40. Speculating with SIF Contracts • A speculative position is simply establishing a position in the SIF market without any offsetting position in the underlying stocks / index • The established position in SIF could be long or short according to whether the speculator is bullish or bearish about market performance Bullish Expectation : Illustration Suppose a speculator believes that the remaining 4 trading days of the week is likely to see an increase in the stock market index and SIF contract value

  41. Strategy: Long one SIF Contract

  42. Bearish Expectation : Illustration Suppose a speculator expects stock and SIF prices to decline over the next several days Strategy : Short One SIF Contract

  43. Spread TradingSpread trading is essentially a speculative strategy but one that has a safety net Bull Time-Spread : Illustration Suppose an investor believes stock prices are likely to increase over the future Example: Today’s Date : Jan 15 Prices Quoted March SIF Contract = 1100 points June SIF Contract = 1104 points

  44. Strategy: Short 1 March Contract Long 1 June Contract

  45. Suppose the SIF price on Jan. 30th were as above, the spread trade would have profited RM300, derived as follows; • Loss on March contract = 8 points x RM50 = (RM400) • Gain on June contract = 14 points x RM50 = RM700 ----------------------- Net Gain = RM300 ============= The gain of RM300 came from the increasein the spread from 4.00 points on Jan. 15 to 10.00 points on Jan. 30th

  46. Bear Time Spread : Illustration A Bear time spread is the opposite of the above, when prices are expected to fall, the distant contract would typically fall more than the nearby contract Strategy: Long the near by month contract. Short the distant month contract

  47. SIF Contracts and Portfolio Management • Adjusting Portfolio Betas and • (ii) Asset Allocation • Adjusting Portfolio Beta : Illustration You currently hold a portfolio that has a beta of 1.5. You are worried about impending volatility in the stock market over the immediate future. you want to reduce your portfolio beta to a more acceptable 1.0 beta. How can you use SIF contracts to do this? Information; Current Portfolio value = RM6,000,000 Portfolio beta = 1.50 Index level = 1,000 pts. Intended Portfolio beta = 1.00

  48. Answer: • Amount of Portfolio to Hedge = • RM6,000,000 x [1-(1.00/1.50)] = RM2,000,000 • So, RM2 million worth of your portfolio should be hedged • Number of SIF contracts = RM2,000,000 = 40 contracts 1,000 x RM50 • New Portfolio Beta = RM4 mil (1.50) + RM2 mil. (0) RM 6 mil RM6 mil = .67(1.50) =1.00 beta

  49. Adjusting Asset Allocation • Asset allocation becomes a much cheaper strategy with SIF contracts. As we saw earlier, SIF contracts can be used to synthesize or ‘create’ t-bill positions with stocks • A fund manager could easily mimic the desired t-bill position by simply combining the right proportion of SIF contracts to his current stock position • To increase the t-bill position fund manager would short more SIF contracts and the opposite in order to reduce the t-bill position

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