STOCK INDEX FUTURE CONTRACTS EXPLORING NEW AVENUES TO HEDGE

MARIAM NASIR
Manager Research
Sep 03 - 09, 2007

In Pakistan, though derivatives have been a relatively new concept until recently, the derivative volume has increased manifold amidst the changing market and regulatory environment. During the last one year, derivative transactions have grown substantially owing to the growing interest of the market players. So far, foreign banks have been quite active in carrying out derivative transactions as the major chunk of these transactions lies with such banks. Keeping in view the international standards and practices the management of the Karachi bourse has announced to launch the Stock Index Future Contract. It will be one of the core components of derivate instruments available where the underlying commodity is KSE-30 Index. Stock indexes cannot be traded directly, so futures based upon stock indexes are the primary way of trading stock indexes. As index futures are based upon the prices of many separate trading entities, they are usually settled in cash, rather then delivery of the underlying stocks. This means that if a trader is holding a futures contract when it expires, their profit or loss will be calculated using the final settlement price determined by the exchange, and their trading account will be adjusted by their profit or loss.

STOCK INDEX FUTURES CONTRACT

Stock index futures are traded in terms of number of contracts. Each contract is to buy or sell a fixed value of the index. The value of the index is defined as the value of the index multiplied by the specified monetary amount.

HISTORY

Trading in stock index futures contracts was introduced by the Kansas City Board of Trade on February 24, 1982. In April 1982, the Chicago Mercantile Exchange (CME) began trading in futures contract based on the Standard and Poor's Index of 500 common stocks. The introduction of both contracts was successful, especially the S&P 500 futures contract, adopted by most institutional investors.

WHY BUY INDEX FUTURES?

Academic literature on the subject shows that, in some cases, the introduction of the index futures has actually reduced the volatility in the underlying index. The theory behind this is interesting. Technical analysts thrive on their ability to predict the movement of the broad market indices. However, as they cannot trade the index, the normal practice is to try to capture a relation between the index and individual stocks. The introduction of the futures contract on stock indices gives them the opportunity to actually buy into the components of the index. The other important use of stock index futures is for hedging. Mutual funds and other institutional investors are the main beneficiaries. Hedging is a technique by which such institutions can protect their portfolios from market risks. Historically, stock index futures have supplemented, and often replaced, the secondary stock market as a stock price discovery mechanism. The futures market has heralded institutional participation in the market with increased velocity and concentration on stock-trading. Programme-trading and index arbitrage are necessary for an efficient and thriving futures market. However, on the flip side, these strategies have increased the risks associated with stock specialists. The increased concentration, the velocity of futures trading, and the resultant increase in volatility in the stock market, may have a long-term impact on the participation of individual investors in the market. However, index futures provide investors an efficient and cost-effective means of hedging and significant improvements in market timing. The introduction of index futures need not necessarily be bad for the capital market, so long as proper checks are in place to prevent unwarranted speculation.

Given below are some of the benefits of the Index Derivatives:

* Broad equity diversification with a single transaction.

* Actively quoted markets with transparent pricing.

* Flexibility to enter and exit the market at any time during the trading day.

* No restriction for short-selling the market.

* Mitigation of counterparty risk considerations because of daily cash settlements of trading gains and losses.

* Liquidity (namely, narrow bid-ask spreads) as a consequence of concentrated trading activity in standardized contracts with broad-based market appeal.

FUTURES CONTRACTS ON STOCK INDEXES MAY HINT AT MARKET DIRECTION

You can get a clue about where after-hours traders are thinking the market will open by looking at the indexes in relationship to "fair value." Fair value is the relationship of a market index to its futures contract. If the futures are higher than the fair value, then traders are betting the market will open UP. However, if the futures are lower than the fair value, traders are looking for the index to open lower. This is not a precise measure and it will change during the night. The closer it is to market opening, the more reliable this gauge becomes. You will hear the electronic media reporting this relationship before the market opens or you can go to any number of sources and get the information yourself.

FUTURE OUTLOOK

The current working for the Stock Index Future Contract is under study. While it will take a couple of weeks to finally launch it after approvals from the apex regulators and the members, the next step in order to supplement the Stock Index Futures Contracts, is to introduce sector wise Index thereby representing all economy sectors. It is important to understand that the Index varies only because prices of the underlying component stocks change. In particular, the Index is unaffected by payments of dividends and/or any changes in the composition of the Index.