Version 1/9/2001

FINANCIAL ENGINEERING:
DERIVATIVES AND RISK MANAGEMENT
(J. Wiley, 2001)

K. Cuthbertson and D. Nitzsche

Lecture

Stock Index Futures

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Topics

Basic Concepts

Speculation

Hedging

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Basic Concepts

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Stock Index Futures:Terminology

Hold, TVS0 = $2m in diversified equity portfolio

and stock index S0= 200

Number of index units in stocks,Ns =TVS0/S0=10,000

shares

ie. For each unit change in the index S, then the value
of the stock portfolio changes by $10,000 (DOLLARS)

(TVS)t = Ns St

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Stock Index Futures:Terminology

F0 = 202
z = contract size
= $500 per index point - for S&P 500

Then the face value of one futures contract is

FVF0 = z F0 = $500 ( 202 ) = $101,000

Fear a fall in equity prices : what do I do to

hedge ?
Short the futures
How many futures contract do I short ?

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 Specualtion

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Figure 3.2 : Speculation: Nikkei index (Leeson)

24000

Leeson buys
22000

20000

18000

16000

14000
Leeson closes out / sells
Five eights make $1.4bn ?
12000
03/01/94 03/07/94 03/01/95 03/07/95 03/01/96 03/07/96

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 Hedging
with
Stock Index Futures

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Minimum Variance Hedge Ratios

V
= change in spot market position + change in futures position
= Ns .(S1-S0) + Nf (F1 - F0) z
= Ns . S + Nf (F) z

where, z= contract multiple ($500 for S&P 500)

S = S1 - S0,
F = F1 - F0
The variance of the hedged portfolio is

2 2 2 2 2
V ( N s ) S ( N f . z ) F 2 N s N f . z S ,F

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Minimum Variance Hedge Ratio(1)

Choose Nf to minimize variance, gives:

TVS 0 Value of Spot Position

Nf .
z.S 0 Value of spot index at t 0

is the regression beta for the absolute change

in your portfolio price S regressed on the
absolute change in F:
ie. = (S, F)/ 2(F) = (S)/ (F)

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Minimum Variance Hedge Ratio-(2)
Equivalent expression

TVS0
Nf . p
FVF0
Value of Spot Position
.
FaceValue of futures at t 0
p
p is the regression beta for the percentage change in
your portfolio S (ie. the portfolio return) regressed on the
percentage change in F. In practice hedging error arises
because p is an estimate and may not hold over the
future.
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End of Slides

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