Enhancing Your Portfolio With Stock Index Futures?

 What is a Stock Index?

A stock index is an index calculated based on a selected "basket of stocks" reflecting the performance of the overall stock market or a particular sector. Investors view the index as a benchmark to evaluate whether the stock market is going up or going down. These stock indexes are often viewed as the general economic performance of the country as it is often widely followed by economists, fund managers and equity investors.

A stock index furtures contract is one whose value or prices is being derived from the underlying index. These products are traded on organised exchanges and have standardised trading units (commonly called contract size). Some of the most tradable stock index futures are the US S&P500, Dow Jones, the Nadasq index, the Japanese Nikkei 225, the German Dax 30, the British FTSE 100 and the Frence CAC 40. In the year 2005, we saw the Global Equity Index derivatives soar nearly 8 percent to 4,080,000,000 contracts or 41 percent of the total global deriatives contracts making it the top category of futures and options traded worldwide. In Singapore, the SGX MSCI Singapore Index and Nikkei 225 futures are the more popular index futures traded here.

Methodology of Calculating an Index

There are a few methods used in calculating a stock index. Back in 1982, the first stock index futures launched in Kansas City Board of Trade was the Value Line Index futures contract. This index is based on an equal-weighting of each of the 1,700 stocks traded in the NYSE. Every stock was assigned an equal weighting in the calculation. Then we have a price-weighted index like the popular Dow Jones Industrial Index and the Japanese Nikkei 225 index. Each constituent stock price is given a certain weighting. The third and probably the most popular and widely used method is the market capitalisation weighted index like the S&P 500, Hang Seng Index, the Japanese Topix and the MSCI Indices. In the market capitalisation weighted method, the prices of each stock is mutiplied by the number of stocks floated in the market to derive its market value. At Singapore Exchange, the MSCI Singapore free index is market capitalisation weighted based on the 38 constituent stocks. Individuals stocks that are chosen in an index generally need to fulfill a few basic requirements. The constituent stock must have a certain market capitalisation and be liquid and actively traded. Stocks chosen must be spread across various sector to have a wide representation of the economy, high correlation movement of the overall market and normally constitute at least 60 percent of the total market capitalisation.

What are the Advantages of using Stock Index Futures?

There are many advantages and benefits of using stock index futures contract. Most evident is the leverage effect in using futures contract. In futures trading, traders only need to place a small amount of funds known as initial margin to enable participants to buy or sell futures contracts. This margin, known as a performance bond or good faith deposit, is approximately 5 to 10 percent of the actual contract value. In other words, capital requirement will be reduced greatly and participants need not tie up their funds. Hedgers and speculators alike will find it more cost effective to do business. As an index reflect the overall performance of the stock market, it is easier to trade the overall market through an index rather then stock picking. Price transparency and market liquidity is another added advantage to index futures trading as participants gain equal opportunities and easy accessability to trade the futures contract. The futures market also allows short-selling if they view the market is weak and may first fall, unlike share trading where an investor has to own the stocks before they can sell or they have to borrow scips (which may be costly and inconvenient) to sell if they view the market may fall.

Now with the advancement in information technology, many futures contracts are traded online and participants can have easy access by tapping on the keyboard to execute trades. The cash settlement method for expiring stock index futures contracts also free participants from worries and concerns about high cost of physical deliveries during expiration. Commission fees are also generally cheaper when trading stock index futures as compared to share trading. A stock that has a value of SGD50,000 may be charged a commission fees of SGD125.00 (based on 0.25 percent) while a contract of SiMSCI value at SGD50,000 may be charged between SGD10.00 and SGD20.00 per lot.

Hedging a Portfolio of Stocks using Index Futures contracts

One of the primary functions of futures exchanges is hedging. The existence of the futures market which originate some 200 years ago from commodities trading allow farmers and producers to hedge their crops and commodities. Hedging is the term used to minimise or transfer price risks caused by market price fluctuation. In practice, hedging is the means of taking an opposite direction in the futures market to "lock in" your cash or physical commodity. Likewise in the stock market, an investor who bought shares while fearing a short-term fall in prices but unwilling to sell his cash portfolio, may use the stock index futures contract to hedge his cash position.

Here are the 38 constituent stocks of the MSCI Singapore Free Index with its weightings as of 1 September 2006.

Very often hedging can be a means of substitute sale or purchase against the cash market. What is important in hedging is to choose a futures contract that has a very high correlation in-order to make an effective hedge. Secondly the hedge ratio, which is the number of stock index futures contracts required to hedge a cash position, needs to be defined and calculated. Let me brief give a simple illustration. An investor is holding Singapore blue chip shares worth SGD500,000 and he is keeping it as a long-term investment. Fearing that prices are due for some correction in the nest few months, he used the MSCI Singapore Index to hedge. The current price of the futures index is trading at 295.0 and each of the trading unit is SGD200 x Index which is 295.0 x SGD200 = SGD59,000 per lot. The investor will need to calculate how many lots he needs to hedge his portfolio of SGD500,000. To calculate the hedge ratio, simply use the portfolio value/futures value which is 500,000/59,000 = 8.47 lots of stock index futures. The investor may choose to sell 8 or 9 lots futures to hedge his holdings. This is technically known as a short hedge as he is long cash and short index futures. After the hedge is taken, should the stock market fall, losses in the portfolio will be off-set by the gains in the futures contract and vice versa. Investors should take note that cash and futures prices do not move 100 percent in tandem and therefore "basic risks" exists. The other concern of hedging which must be taken into consideration is the cost involved. These are basically margin requirements, variation margin calls and commission fees. More details of hedging should be discussed with your broker or trading advisers before you embark on any hedging strategies.

The FTSE/Xinhua China A50 Index Futures Contract

Singapore Exchange, in its aim to be a Financial and Asian Trading Hub in the region, has recently launched the new FTSE/Xinhua China A50 Futures Index contract on 5 September 2006. This initiation is largely applauded as many market participants view China, the fourth largest economy in the world, as one of the new economic giants and power. As the Chinese markets are not fully opened to outsiders and foreign investors yet, investors and fund managers now can gain access to the Chinese market directly or indirectly via this index.

This stock index is calculated jointly by the FTSE group and China Xinhua Finance on a well diversified market capitalisation weighted basis of the largest 50 A shares listed both on the Shanghai and Shenzhen stock exchanges. A summary of the Index Futures contract specifications is as follow with an initial margin requirement set at USD2,750 per lot.                                                    - Yeo Ek Meng, Man Financial (S) Pte Ltd