Chapter 4

Stock Index Futures Contracts;

Analysis And Applications
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
 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.
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)
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.
•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
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

•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
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

P i
Index  i 1
Divisor

Where,
Pi = closing price of each component stock.
Divisor = statistical adjustment factor for capitalization changes;
stock splits, bonus issues, rights, and stock substitution
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

 n

N i ,t  Pi ,t
Index  t 1
xM
O V
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
Example of Computation

Suppose there are 3 stocks in the Index and computation begins on day t =
1

Stoc Number of Stocks Close Price on Close Price on

k Outstanding day; t = 1 day; t =2
A 5,000 5.00 5.40

B 10,000 7.00 6.80

C 6,000 6.00 6.50

 5,000(5.00)  10,000(7.00)  6,000(6.00)
Indext 1  x 100  100 Points
5,000(5.00)  10,000(7.00)  6,000(6.00)

5,000(5.40)  10,000(6.80)  6,000(6.50)

Indext  2  x 100
5,000(5.00)  10,000(7.00)  6,000(6.00)

134,000
 x 100  102  29 Points
131,000
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)
The value of each futures contract is

1,000 pts x RM50 = RM50,000

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
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

 Sincethe 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

 Themain players would therefore be institutions like Pension Funds,

Insurance Companies, Fund Management operations of Merchant
Banks, Asset Management companies, Mutual Funds, etc
The Pricing of SIF Contracts

Ft ,T  S o (1  r f  d ) t ,T

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
Using the Cost of Carry Model

An 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 RM50

What would be the correct price of a SIF contract if it matures in (i) 3 months (ii)

6 months and (iii) 1 year?

3-Month Maturity

F  S o (1  rf  d )1/ 4
F  960 (1  06  02).25
F  960 (1.04).25  960(1.01)  969.46 points
Since Multiplier is RM50 = 969.46 points x RM50
Ringgit Value Per Contract = RM48,473.00
6-Month Maturity
1 year Maturity
F = 960 (1 + .06 - .
02)1/2 F = 960(1 + .06 - .02)1
= 960 (1.04).5 = = 960 (1.04)1 = 998.40
979.01
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
 If Ft> 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
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
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

Long Spot Short Futures

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
Scenario 1: Index Rises to 1225
Cash & Carry Arbitrage

Action Position Position At Profit/Loss

Today Maturity

(I) Short

(I) Long

Net =
Scenario 1: Index Rises to 1225
Cash & Carry Arbitrage

Action Position Position At Profit/Loss

Today Maturity

(I) Short 1 SIF Contract 60,500 (61,250) (750)

(I) Long Spot (60,000) 61,250 1,250

(I) Borrow RM60,000 60,000 (60,591.20) (591.20)

@ 4% for 90 days.

(I) Receive divs. and 0 303 303

invest it @ 4% for
90 days.
Net = 211.80
Scenario 2: Index Falls to 1175
Cash & Carry Arbitrage

Action Position Position At Profit/Loss

Today Maturity

(I) Short 1 SIF

Contract
(I) Long Spot

(I) Borrow RM60,000

@ 4% for 90
days.
(I) Receive divs. and
invest it @ 4% for
90 days.
Net =
Scenario 2: Index Falls to 1175
Cash & Carry Arbitrage

Action Position Position At Profit/Loss

Today Maturity

(I) Short 1 SIF 60,500 (58,750) 1,750

Contract
(I) Long Spot (60,000) 58,750 (1,250)

(I) Borrow RM60,000 60,000 (60,591.20) (591.20)

@ 4% for 90
days.
(I) Receive divs. and 0 303 303
invest it @ 4% for
90 days.
Net = 211.80
Reverse Cash and Carry Arbitrage

Suppose 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
Index Rises to 1225

Action Position Position At Profit/Loss

Today Maturity

(I) Long 1 SIF Contract

(I) Short

Net =
Index Rises to 1225

Action Position Position At Profit/Loss

Today Maturity

(I) Long 1 SIF Contract 60,050 61,250 1,200

(I) Short Spot 60,000 (61,250) (1,250)

(I) Lend RM60,000 @ (60,000) 60,591.20 591.20

4% for 90 days.

(I) Borrow RM300 @ 0 (303) (303)

4% to replace divs.
on borrowed shares
(shorted).
Net = 238.20
Index Falls to 1175

Action Position Position At Profit/Loss

Today Maturity

(I) Long

(I) Short

Net =
Index Falls to 1175

Action Position Position At Profit/Loss

Today Maturity

(I) Long 1 SIF Contract 60,050 58,750 (1,300)

(I) Short Spot 60,000 (58,750) 1,250

(I) Lend RM60,000 @ (60,000) 60,591.20 591.20

4% for 90 days.

(I) Borrow RM300 @ 0 (303) (303)

4% to replace divs.
on borrowed shares
(shorted).
Net = 238.20
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)

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
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
Scenario 1 : The Stock Market falls 20%

Action Position Position At Profit/Lo

Today Maturity ss

(1) Portfolio Value 1,200,000 912,000 (288,000)

(1) Short 24 SIF 1,454,184 1,152,000 302,184

Contracts.

(1) Dividends - - 6,000

Received till
Maturity.

Net = 20,184
Note:

Since beta of portfolio is 1.2; portfolio value falls 24% when market
falls 20%

AtMaturity; 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
Scenario 2: The Stock Market Rises 20%

Action Position Position At Profit/Loss

Today Maturity
(1) Portfolio Value 1,200,000 1,488,000 288,000

(1) Short 24 SIF 1,454,184 1,728,000 (273,816)

Contracts.

(1) Dividends - - 6,000

Received till
Maturity.
Net = 20,184
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%
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%.
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:

RM 20,184  RM 1,440
X 4  0.062or 6.2%
RM 1,200,000

(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)
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
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
Strategy: Long one SIF Contract

Day Index RM Amount Profit / Loss Accumulated

Close P/L
0 1200 60,000 0 0

1 1212 60,600 600 600

2 1208 60,400 (200) 400

3 1205 60,250 (150) 250

4 1214 60,700 450 700

Bearish Expectation : Illustration

Suppose a speculator expects stock and SIF prices to decline over

the next several days

Strategy : Short One SIF Contract

Day Index Close RM Amount Profit / Loss Accumulated

P/L
0 1200 60,000 0 0

1 1188 59,400 600 600

2 1182 59,100 300 900

3 1187 59,350 (250) 650

4 1183 59,150 200 850

Spread Trading

Spread 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
Strategy: Short 1 March Contract
Long 1 June Contract

(Today) Jan. (2 Weeks later) Jan. Gain/Loss

15th 30th

Mar. SIF 1100 1108 (8 points)

June SIF 1104 1118 + 14 points

Spread 4.00 10.0 6.0 points

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 increase in the spread from
4.00 points on Jan. 15 to 10.00 points on Jan. 30th
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
SIF Contracts and Portfolio Management

(i) 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
Answer:
  
 Amount of Portfolio to Hedge = Portfolio Value x 1   Intended Beta 
  Actual Beta 

 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
• 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
 Issues in SIF Pricing

 Violations to Spot-Futures Parity

(a) Transaction Costs and the No-Arbitrage Bounds

(b) Inefficiencies
(c) Order Imbalances
(d) Regulation and other hindrances
Issues in Stock Index Futures Trading

(a)Volatility of Underlying Stock Market

(b) Volume Migration from Spot to SIF

(c) Lead-lag Relationships in Returns and Volatility

(d) Patterns in Intraday Trading and Volatility

(e) Intermarket Spread Trading

Single Stock Futures (SSF)

A Single Stock Futures Contracts (SSF) is a equity futures contract which has a
single stock as its underlying asset

Bursa Malaysia has offered for trading 10 SSF contracts, essentially,

futures contracts on 10 blue-chip stocks

 Bursa Malaysia Bhd  IOI Corp. Bhd.

 Air Asia Bhd  Maxis Bhd

 AMMB Holdings Bhd  RHB Capital

 Berjaya Sports Toto Bhd  Scomi Group

 Genting Bhd  Telekom Malaysia

SSF – Trading Mechanics

Operationally, trading SSF contracts is very similar to that of Stock Index

Futures (SIF) contracts

at maturity, one closes out one’s position by taking out the profits in
the margin account if a profit has been made or closing the position
having already paid the margins if a loss has been made

No physical delivery takes place in both cases.

Why Use SSF Contracts

 SSFs provide automotive leverage

 They have lower transaction costs, can be used to lower risk (hedging),
to short a stock, and like SIFs
 they can be used to alter the beta of a portfolio
 SSF Contracts can be used for hedging, arbitrage and speculation in
addition to other stock specific use
So

Pricing a SSF Contract

Pricing a SSF contract is based on the same logic of SIF contracts.

A SSF contract is priced based on the cost of carry model

SSFt ,T  S o 1  rf  d 
t ,T

Where;
S0 = current price of underlying stock
rf = risk free interest rate
d = expected dividend yield in %
t,T = time to maturity
SSF Pricing – Illustration

A stock is currently selling at RM12.00. The stock is expected to pay a

dividend of 30 sen over the next 90 days. If the risk-free interest rate is
6%, what should the correct price be for a 90 day SSF contract on the
stock
SSFt ,T  S o 1  rf  d 
t ,T

Since a 30 sen dividend per stock is due, the dividend yield on the
stock is

 RM 0.30 
 RM 12.00  x 100  2.5%
 
Therefore,

SSFt , T  RM 12.00 1  .06  0.025

.25

 RM 12.00 1.035
.25

 RM 12.00 1.008637
 RM 12.10
The 90 day, SSF would therefore sell at a 10 sen premium over the
spot price
Given the cost of carry model; the following relationships hold between the
SSF value and its determinants

For an increase in Value of SSF

• Stock price (S0) Increases

• Interest rate (rf) Increases

 Dividend yield (d) Decreases

 Time to maturity t,T Increases

 SSF – Applications

• Hedging with SSF Contracts

• Arbitraging with SSF Contracts
• Speculating with SSF Contracts