Understanding Stock Index Futures


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Introduced in 1982, stock index futures have grown to become perhaps the second-most significant sector, after interest rates, within the futures trading community, CME Group analysts said in a report.

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Understanding Stock Index Futures

  1. 1. STOCK INDEXESUnderstandingStockIndexFuturesMAY 3, 2013John W. Labuszewski John Nyhoff David GibbsManaging Director Executive Director DirectorResearch & Product Development312-466-7469jlab@cmegroup.comResearch & Product Development312-930-2310John.nyhoff@cmegroup.comProduct Marketing312-207-2591David.gibbs@cmegroup.com
  2. 2. 1 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPStock index futures were introduced in 1982 ondomestic futures exchanges and have since grown tobecome perhaps the 2ndmost significant sector,after interest rates, within the futures tradingcommunity.Actually, the concept of a stock index futurescontract had been discussed and analyzed for manyyears prior to 1982, but a variety of regulatory andintellectual property rights issues held the conceptback. These issues were addressed by 1982,leading to the introduction of futures based on theStandard & Poor’s 500 Index (S&P 500) on theChicago Mercantile Exchange (CME) as well as manyother stock index contracts.The basic model established in the early 1982 forthe trade of stock index futures was embraced on adomestic and global basis by many other exchanges.As a result, we now enjoy a vibrant array of stockindex futures for access by institutional and retailtraders alike.Mechanics of Stock Index FuturesFor the most part, our discussion focuses on severalextremely successful stock index futures contractsthat share common design characteristics. We arereferring to the “E-mini” line of stock index futuresproducts as offered on CME Group exchangesbeginning in 1997.These contracts are traded exclusively on electronictrading platforms such as the CME Globex® systemand constructed with relatively modest contractsizes relative to the original or “standard-sized”stock index futures based on the particular index.The original S&P 500 futures contract, introduced in1982, was based on a value of $500 times the indexvalue. In the intervening years, equities generallyadvanced in value. Thus, the exchange found it wasoffering a contract with a high contract value. As aresult, the contract was “split” in 1997 such that thecontract multiplier was halved from $500 to $250times the Index.Still, the contract value was high relative to manyother extant futures contracts. Thus, the exchangeoffered an alternative “E-mini” S&P 500 contractvalued at $50 times the index and traded exclusivelyon an electronic basis, as opposed to in theexchange pits via open outcry, beginning in 1997.The E-mini design was widely accepted and rapidlygrew to become the most popular line of stock indexfutures available today.Like all stock index futures contracts, E-minis arevalued at a specified contract multiplier times thespot or cash index value. They call for a cashsettlement at said value, generally during thecontract months of March, June, September, andDecember (the “March quarterly cycle”). Thesecontracts are traded on electronic trading platformsfor most of the 24-hour weekday period beginningon Sunday evenings.Exhibit 1 in our appendix below illustrates thecontract specifications of the four most popular E-mini stock index futures.Contract Value & QuotationStock index futures are quoted in terms of theunderlying or spot or cash index value in indexpoints. Exhibit 2 in our appendix below depictsquotations for the E-mini S&P 500 futures contract.But the monetary value is a function of the contractmultiplier and quoted index value. = E.g., June 2013 E-mini S&P 500 futures contractsettled at 1,573.60 index points on April 23, 2013.The monetary value of one contract may be0500,0001,000,0001,500,0002,000,0002,500,0003,000,0003,500,0002000200120022003200420052006200720082009201020112012Major E-mini Equity Futures ADVE-mini S&P 500 E-mini Nasdaq-100E-mini ($5) DJIA E-mini S&P MidCap
  3. 3. 2 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPcalculated as $78,680. = $50 1,573.60 = $78,680Stock index futures are quoted in a specifiedminimum increment or “tick” value. The minimumallowable price fluctuation in the context of the E-mini S&P 500 futures contract is equal to 0.25 indexpoints. This equates to $12.50 per tick as shownbelow. ! " # $ = % % = $50 0.25 = $12.50We may value and define the tick size of the fourpopular stock index futures mentioned above asseen in Exhibit 3 in our appendix below.Cash Settlement MechanismStock index futures do not call for the delivery of theactual stocks associated with the stock index. Sucha delivery process would be quite cumbersome tothe extent that a stock index may be composed ofhundreds or even thousands of constituents.The logistical difficulties are compounded to theextent that it’s necessary to weight the delivery ofeach stock issue by exacting reference to theirweights as represented in the stock index. But theindustry addressed this problem by introducing theconcept of a cash settlement mechanism.A cash settlement is actually quite simple. Afterestablishing a long or short position, marketparticipants are subject to a normal “mark-to-market” (MTM) like any other day. I.e., they payany losses or collect any profits daily and in cash.Subsequent to the final settlement day, positionssimply expire and are settled at the spot value of theunderlying index or instrument.Domestic stock index futures typically employ a finalsettlement price that is marked to a “special openingquotation” (SOQ) on the third Friday of the contractmonth. The SOQ is intended to facilitate arbitrageactivity by allowing arbitrageurs to enter market onopen (MOO) orders to liquidate cash positions at thesame price that will be reflected in the finalsettlement price. A morning settlement or SOQprocedure was established in late 1980s to avoid theso-called triple witching hour where stocks, stockoptions, and stock index futures would all concludetrading at the same time of day on the 3rdFriday ofthe contract month.Pricing Stock Index FuturesStock index futures cannot be expected to trade at alevel that is precisely aligned with the spot or cashvalue of the associated stock index. The differencebetween the futures and spot values is oftenreferred to as the basis. We generally quote a stockindex futures basis as the futures price less the spotindex value. = − ) * E.g., the June 2013 E-mini S&P 500 futures pricewas 1,573.60 with the spot index value at 1,578.78as of April 23, 2013. Thus, the basis may be quotedas -5.18 index points (= 1,573.60 – 1,578.78). = 1,573.60 − 1,578.78 = −5.18The basis will generally reflect “cost of carry”considerations, or the costs associated with buyingand carrying the index stocks until futures contractexpiration. These costs include financing costs, perthe assumption that one is a leveraged buyer of theequities, and a payout represented by the dividendsthat are expected to accrue until the futuresexpiration date. Thus, the futures price may beestimated as follows. = ) * + ℎ -− . /Fair ValueThe gap or difference between spot index values andtheoretical futures prices is often referred to as fairvalue. This is the level at which futures pricesshould be expected to trade, albeit not necessarilywhere they will trade relative to the spot indexvalue. = ℎ - − . /The fair value of a stock index futures contract isnormally expected to be positive such that futuresprices > spot prices. This is attributable to the factthat finance charges, as reflected in short-term
  4. 4. 3 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPinterest rates such as the London Interbank OfferedRate (LIBOR), normally exceed dividend yields.Negative carry is said to prevail where short-terminterest rates exceed dividend yields. This may beunderstood by considering that this implies it costsmore to finance the purchase and carry of a basketof stocks, as represented in an index, than thepayouts associated with the stock basket in the formof dividends.When negative carry prevails, stock index futurestend to price at higher and higher levels insuccessively deferred months extending out into thefuture; and the basis, quoted as futures less spot, isquoted as a positive number.Positive carry is said to prevail under circumstanceswhere short-term interest rates are less thandividend yields. Under these conditions, the payoutsor dividends associated with the basket of stocksrepresented in the index provide a superior return toshort-term interest rates. Hence one may earn apositive return by buying and carrying the basket.Positive carry is not typical as it implies that acorporation offering dividends in excess of short-term rates cannot apply those funds in such a wayas to earn a superior return. But it is notuncommon as positive carry prevails as this is beingwritten, noting that the Federal Reserve had easedshort-term rates to unprecedented low levels in late2008.When positive carry prevails, stock index futurestend to price at lower and lower levels insuccessively deferred months extending out into thefuture and the basis, quoted as futures less spot, isquoted as a negative number.Basis ConvergenceRegardless of whether positive or negative carryprevails, the design of a stock index futures contractassures that the basis or difference between futuresprices and spot index values will fall to zero by thetime futures contract maturity rolls around. This isintuitive to the extent that stock index futures aresettled in cash at the spot index value on its finalsettlement date.The process by which futures and spot value cometogether over time is known as convergence. Notethat, regardless of whether equity prices in generalare trending upward or downward, the basis issteadily converging toward zero.-60-40-200204060t+0 t+1 t+2 t+3 t+4 t+5 t+6 t+7Positive and Negative CarryPositive CarryDividends > S-T RatesNegative CarryDividends < S-T Rates0%1%2%3%4%5%6%7%Jan-06Jul-06Jan-07Jul-07Jan-08Jul-08Jan-09Jul-09Jan-10Jul-10Jan-11Jul-11Jan-12Jul-12Jan-13Short-Term Rates & Dividend Yields1-Mth LIBOR S&P 500 Dividend Yield1,2001,2501,3001,3501,4001,4501,5001,5501,600Jan-12Feb-12Mar-12Apr-12May-12Jun-12Jul-12Aug-12Sep-12Oct-12Nov-12Dec-12Jan-13Feb-13Mar-13S&P 500 Spot vs. FuturesS&P 500 Mar-13 Futures
  5. 5. 4 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPThat is not to say that basis convergence is alwayscompletely smooth or predictable. In fact, there maybe considerable “flutter” in the process on a day-to-day basis. Some of that flutter may be attributed tothe fact that stock index futures are often tradedsome minutes beyond the time of day that the cashstock exchanges close and settle equity values.CME Group routinely offers stock index futures some15 minutes after the close of the NYSE on a dailybasis. Although 15 minutes is not a terribly longperiod of time, there is always some probability thatbreaking news may push futures prices upward ordownward to diverge from movements in theunderlying stock markets.As a result, CME Group has implemented a “fairvalue settlement procedure” on the last day of eachcalendar month with respect to its domestic stockindex futures contracts. On a normal day, the dailysettlement value is established by reference to anindicative market price that may have beenexecutable during the final minutes of trade on thatparticular day.But the fair value settlement procedure providesthat, regardless of where futures prices are inrelationship to the spot index value, they will besettled at their fair value (FV). That FV is calculatedbased on a survey of applicable interest rates anddividends to accrue until expiration date.E.g., on March 28, 2013, the surveyed short-termrate was 0.350%; there were 84 days between thesettlement date of April 3, 2013 to the June 21,2013 expiration of June 2013 futures; the spot valueof the S&P 500 index was at 1,562.85; and,dividends accruing until futures contract expirationwere estimated at 7.831 index points. The FV of theJune 2013 futures contract was calculated at 6.555index points below spot. = ℎ - − . /= 01 233604 * 5− . /= 00.350% 2843604 1,562.855 − 7.831= −6.555Thus, the contract was settled at a value of1,556.30, or 1,556.295 (= 1,562.85 – 6.555)rounded to the nearest integral multiple of 0.10index points. 1Enforcing Cost of Carry PricingDespite some degree of “flutter,” liquid stock indexfutures markets tend to price efficiently and inreasonable close conformance with their fair values.That is due to the fact that many marketparticipants are prepared to “arbitrage” anyapparent mispricing, or pricing anomalies, betweenspot and futures markets.If futures prices were to rally much above their fairmarket value, an astute arbitrageur may act to buythe stock portfolio and sell stock index futures in anattempt to capitalize on that mispricing. Thesearbitrageurs may attempt to trade in a basket orsubset of the stocks included in a stock index. Or,the state of electronic trading systems may providethem the means to trade in all or virtually all of theconstituents of a particular stock index as part of thearbitrage transaction.In the process of buying stocks and selling futures,the arbitrageur may bid up the stocks or pushfutures prices down to reestablish an equilibrium1The minimum price fluctuation or “tick” size associatedwith the E-mini S&P 500 futures contract equals 0.25index points while the tick associated with the“standard” sized S&P 500 futures contract equals 0.10index points. But both E-mini and standard futures aresettled on a daily basis at the nearest integral multipleof 0.10 index points, corresponding to the tickassociated with the standard sized contract.-35-30-25-20-15-10-505Jan-12Feb-12Mar-12Apr-12May-12Jun-12Jul-12Aug-12Sep-12Oct-12Nov-12Dec-12Jan-13Feb-13Mar-13Mar-13 S&P 500 Basis(Futures - Spot)
  6. 6. 5 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPpricing situation where arbitrage is ostensibly notprofitable.E.g., on March 28, 2013, with a settlement onemight have bought S&P 500 stocks reflecting thespot index value of 1,562.85 for April 3rdsettlement,incurring finance charges of 0.350% or 1.276 indexpoints, carrying the stocks and earning dividendsequivalent to 7.831 index points. The net cost is1,556.30 and, therefore, futures should price at thislevel.Buy stocks @ levels reflectingspot index value(1,562.85)Incur finance charges @ 0.350% (1.276)Receive dividends of 7.831 index points 7.831Net cost over 84 days (1,556.30)Expected futures price 1,556.30E.g., if futures were to be trading significantly belowtheir fair value, one might sell stocks and buyfutures. This arbitrage should have the effect ofbidding futures prices upward and pushing stockprices downward to reestablish equilibrium pricing.Sell stocks @ levels reflectingspot index value1,562.85Invest proceeds @ 0.350% 1.276Forego dividends of 7.831 index points (7.831)Net cost over 84 days 1,556.30Expected futures price 1,556.30In practice, one must also consider costs attendantto arbitrage, i.e., slippage, commissions, fees, bid-offer spreads, etc. As such, futures tend to tradewithin a band that extends above and below thetheoretical fair value. When futures fall below thatband, one might buy futures and sell stocks; or,when futures rise above that band, one might sellfutures and buy stocks.This band may vary from stock index to stock index,but it would not be unreasonable to assume that thecosts attendant to “arbing” S&P 500 futures fall intothe vicinity of perhaps 1.25 index points. Thus,futures may very well trend upward and downwardwithin that band, reflecting the influx of buy-and-sellorders, without engendering an arbitragetransaction.Spreading Stock Index FuturesSpeculators frequently utilize inter-market spreadsto take advantage of anticipated differentials in theperformance of one market vs. another. CME GroupE-mini S&P Select Sector Stock Index futures lendthemselves nicely for this purpose. 2In order to place an inter-market spread, it isnecessary to derive the so-called “spread ratio.”The spread ratio is an indication of the ratio ornumber of stock index futures that must be held inthe two markets to equalize the monetary value ofthe positions held on both legs of the spread.The following formula may be used for this purposewhere Value1 and Value2 represent the monetaryvalue of the two stock index futures contracts thatare the subject of the spread. 32CME Group E-mini S&P Select Sector Stock Indexfutures (Select Sector futures) were introduced inMarch 2011. The indexes underlying the nine (9)different futures contracts represent subsets of theStandard & Poor’s 500 (S&P 500). Specifically, theseindexes represent the consumer discretionary (IXY),consumer staples (IXR), energy (IXE), financial (IXM),health care (IXV), industrial (IXI), materials (IXB),technology (IXT) and utilities (IXU) sectors of theeconomy. (The info-tech and telecom sectors of theS&P 500 are combined to comprise the technologyselect sector index.) The associated futures contractsare cash-settled to a value of $100 x Index with theexception of the Financials contract which is valued at$250 x Index.3We reference spot index values and not the quotedfutures price for purposes of identifying the monetaryvalue of a stock index futures contract. This convention8509501,0501,1501,2501,3501,450Dec-11Jan-12Feb-12Mar-12Apr-12May-12Jun-12Jul-12Aug-12Sep-12Oct-12Nov-12Dec-12Jan-13Feb-13Dec.31,2011=1,000.00S&P 500 Sector IndexesIXY IXR IXE IXMIXV IXI IXB IXTIXU S&P 500
  7. 7. 6 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUP) 1 = 8 ÷ :E.g., on July 16, 2012, the September 2012 E-miniS&P Financial Select Sector futures contract wasquoted at 146.15 and valued at $36,537.50 (=$250x 146.15). The September 2012 E-mini S&P SelectSector Industrial futures contract was valued at$34,410.00 (=$100 x 344.10).The spread ratio is calculated below at 1.062. Thissuggests that one might balance 20 Financial indexfutures with 21 Industrial index futures.) 1 = ;<=>=?<>@A ÷ B=CDAEF<>@A= $36,537.50 ÷ $34,410.00= 1.062 20 ! 21 Thus, if one believed that financials mightoutperform the industrial sector of the market inmid-2012, one might wish to buy 20 Financial SelectSector futures and sell 21 Industrial Select Sectorfutures contracts. Or, one might opt to trade thespread in a similar ratio, e.g., 1:1, 10:11, etc.If Financials expectedto out-performIndustrialsBuy 20 Financial & Sell21 Industrial futuresThe “spread ratio” provides an indication of theappropriate way to construct an inter-marketspread. Further, it presents a convenient methodfor following the performance of the spread overtime. Because these ratios are dynamic, one mustserves to eliminate cost of carry considerations from thecalculation.be aware of the current spread ratio when placing atrade.This same technique of weighting a spread may bedeployed in the context of any stock index futurescontracts. While we have suggested a speculativeapplication of a spread here, we further consider theuse of spreads in the context of portfoliomanagement applications below.Risk Management with Stock Index FuturesWhile domestic equity markets have been veryvolatile over the past decade, the market has notgenerally produced sizable positive returns. Thiscreates serious challenges for equity asset managersseeking to generate attractive returns whilerelegating volatility to acceptable levels.Thus, we review several popular stock index futuresapplications including (1) beta adjustment; (2)option strategies; (3) cash “equitization”; (4)long/short strategies; (5) tactical rotation; (6)conditional rebalancing; and (7) portable alphastrategies.Measuring RiskThere is an old saying – “you can’t manage whatyou can’t measure.” In the equity market, onegenerally measures risk by reference to the beta (β)of one’s portfolio. But in order to understand β andhow it may be used, we must review the foundationof modern financial theory – the Capital AssetPricing Model (CAPM).0.940.960.981. Spread RatioRatio = ($250 x IXM) / ($100 x IXI)6007008009001,0001,1001,2001,3001,4001,5001,600Jan-06Jul-06Jan-07Jul-07Jan-08Jul-08Jan-09Jul-09Jan-10Jul-10Jan-11Jul-11Jan-12Jul-12Jan-13Standard & Poors 500
  8. 8. 7 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPCAPM represents a way of understanding how equityvalues fluctuate or react to various economic forcesdriving the market. The model suggests that thetotal risk associated with any particular stock maybe categorized into systematic risks andunsystematic risks.# 1 $ = )3 % 1 $ + G 3 % 1 $Systematic risk is a reference to “market risks”reflected in general economic conditions and whichaffect all stocks to some degree. E.g., all stocks areaffected to a degree by Federal Reserve monetarypolicies, by general economic strength or weakness,by tax policies, etc.Unsystematic risk or “firm-specific risks” representfactors that uniquely impact upon a specific stock.E.g., a company may have created a unique newproduct or its management may have introducednew policies or direction which will affect thecompany to the exclusion of others.The extent to which systematic and unsystematicrisks impact upon the price behavior of a corporationmay be studied through statistical regressionanalysis. Accordingly, one may regress the returnsof the subject stock (Rstock) against the pricemovements of the market in general (Rmarket).1HEI?J = K + L M1N>FJOE P + Q Rmarket is generally defined as the returns associatedwith a macro stock index such as the Standard andPoor’s 500 (S&P 500). The alpha (α) or intercept ofthe regression analysis represents the averagereturn on the stock unrelated to market returns.Finally, we have an error term (Є). But the mostimportant products of the regression analysisincludes the slope term or beta (β); and, R-squared(R2).β identifies the expected relative movementbetween an individual stock and the market. Thisfigure is normally positive to the extent that allstocks tend to rise and fall together. β gravitatestowards 1.0 or the β associated with the market inthe aggregate but might be either greater than, orless than, 1.0.E.g., if β=1.1, the stock may be expected to rally by11% when the market rallies by 10%; or, to declineby 11% if the market declines by 10%. Stockswhose betas exceed 1.0 are more sensitive than themarket and are considered “aggressive” stocks.E.g., if β=0.9, the stock is expected to rally by 9%in response to a 10% market rally; or, to decline by9% if the market declines by 10%. Stocks whosebetas are less than 1.0 are “conservative” stocksbecause they are less sensitive than the market ingeneral.If β > 1.0 Aggressive stockIf β < 1.0 Conservative stockR2identifies the reliability with which stock returnsare explained by market returns. R2will varybetween 0 and 1.0.E.g., if R2=1.0, then 100% of a stock’s returns areexplained by reference to market returns. Thisimplies perfect correlation such that one mightexecute a perfect hedge using a derivativeinstrument that tracks the market.E.g., if R2=0, this suggests a complete lack ofcorrelation and an inability to hedge using aderivative that tracks the market.If R2= 1.0 Perfect correlationIf R2= 0 No correlationAn “average” stock might have an R2≈0.30 whichimplies that perhaps 30% of its movements areexplained by systematic factors and “hedge-able.”Thus, the remaining 70% of unsystematic risks arenot hedge-able with broad-based stock indexfutures. 44It is important to establish a high degree of correlationbetween the hedged investment and the hedginginstrument in order to qualify for so-called “hedgeaccounting” treatment. Statement of FinancialAccounting Standards no. 133, “Accounting forDerivative Financial Instruments and Hedging Activities”(FAS 133) generally addresses accounting and reportingstandards for derivative instruments in the UnitedStates. The Statement allows one to match orsimultaneously recognize losses (gains) in a hedgedinvestment with offsetting gains (losses) in a derivativescontract under certain conditions. In particular, it isnecessary to demonstrate that the hedge is likely to be“highly effective” for addressing the specifically identifiedrisk exposure. One method for making suchdemonstration is through statistical analysis. The“80/125” rule suggests that the actual gains and losses
  9. 9. 8 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPE.g., regressing weekly returns of Apple (AAPL) v.the S&P 500 over the two-year period from April2011 through March 2013, we arrive at a β=0.9259and an R2=0.2664. This suggests that AAPL is arelatively conservative company but with insufficientcorrelation to the S&P 500 effectively to use equityindex futures for hedging purposes.E.g., General Electric (GE) is an aggressive stockwith a β=1.1834. GE exhibited reasonably highcorrelation with an R2=0.7325 v. the S&P 500. Still,this correlation may be insufficient to qualify forhedge accounting treatment.of the derivative(s) should fall within 80% to 125% ofthe gains/losses for the hedged item. This may beinterpreted to require an R2=0.80 or better to qualify forhedge accounting treatment. As such, the typical stockwith an R2relative to the index of perhaps 0.30 to 0.50likely cannot qualify for hedge accounting.E.g., Exxon Mobil (XOM) represents another veryheavily weighted stock within the S&P 500. XOMexhibited a β=0.9897 and may be considered aslightly conservative investment. Its R2=0.7390 isreasonably high but not sufficiently high to qualifyfor hedge accounting treatment as a general rule.Traders frequently distinguish between historical orraw or fundamental betas versus so-called adjustedbetas. The historical or “raw” β is calculated basedon historical data as depicted above. Adjusted βrepresents an estimate of the future β associatedwith a security per the hypothesis that β willgravitate toward 1.0 over time. Adjusted β may becalculated as follows. 5R S L = M0.67 ∙ 1 U LP + M0.33 ∙ 1PThus, Apple’s raw β of 0.9259 may be adjusted as0.9504.R S RR V L = M0.67 ∙ 0.9259P + M0.33 ∙ 1P = 0.9504Similarly, General Electric’s raw β of 1.1834 may beadjusted as 1.1229.R S XY L = M0.67 ∙ 1.1834P + M0.33 ∙ 1P = 1.1229Sometimes the formula is further refined based onthe particular economic sector from which the stockoriginates. As such, the value “1” on the right-hand5The Bloomberg quotation system routinely displays anadjusted β. The raw beta is calculated on the basis ofthe past 2 years of weekly returns while adjusted β isdetermined by the formula displayed in the text.y = 0.9259x + 0.0013R² = 0.2664-15%-10%-5%0%5%10%15%20%-8% -6% -4% -2% 0% 2% 4% 6% 8%StockReturnsS&P 500 ReturnsAAPL v. S&P 500 Weekly Returns(Apr-11 - Mar-13)y = 1.1834x - 0.0003R² = 0.7325-10%-8%-6%-4%-2%0%2%4%6%8%10%12%-8% -6% -4% -2% 0% 2% 4% 6% 8%StockReturnsS&P 500 ReturnsGE v. S&P 500 Weekly Returns(Apr-11 - Mar-13)y = 0.9897x - 0.0009R² = 0.7390-8%-6%-4%-2%0%2%4%6%8%10%-8% -6% -4% -2% 0% 2% 4% 6% 8%StockReturnsS&P 500 ReturnsXOM v. S&P 500 Weekly Returns(Apr-11 - Mar-13)
  10. 10. 9 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPside of the equation may be replaced with the betaassociated with the market sector, e.g., financials,technology, consumer durables, etc., from which thestock originates.Hypothetical Stock Portfolio(3/29/13)Ticker Shares Price ValueAdjBetaXOM $90.11 50,000 $4,505,500.00 0.993AAPL $442.66 18,000 $7,967,880.00 0.950GE $23.12 175,000 $4,046,000.00 1.123CVX $118.82 40,000 $4,752,800.00 1.085IBM $213.30 12,000 $2,559,600.00 0.926MSFT $28.61 100,000 $2,860,500.00 0.912JPM $47.46 75,000 $3,559,500.00 1.299PG $77.06 56,000 $4,315,360.00 0.638JNJ $81.53 60,000 $4,891,800.00 0.656T $36.69 50,000 $1,834,500.00 0.750WFC $36.99 75,000 $2,774,250.00 1.168PFE $28.86 98,000 $2,828,280.00 0.794KO $40.44 46,000 $1,860,240.00 0.702BRK/B $104.20 34,000 $3,542,800.00 0.875BAC $12.18 100,000 $1,218,000.00 1.555C $44.24 100,000 $4,424,000.00 1.765SLB $74.89 26,000 $1,947,140.00 1.371ORCL $32.33 73,000 $2,360,090.00 1.117INTC $21.84 107,000 $2,336,345.00 1.013COP $60.10 29,000 $1,742,900.00 0.971PM $92.71 32,000 $2,966,720.00 0.765CSCO $20.90 107,000 $2,235,765.00 0.986WMT $74.83 38,000 $2,843,540.00 0.585VZ $49.15 54,000 $2,654,100.00 0.705MRK $44.20 61,000 $2,696,200.00 0.792HPQ $23.84 45,000 $1,072,800.00 1.212QCOM $66.94 31,000 $2,075,140.00 1.051GS $147.15 10,000 $1,471,500.00 1.244DIS $56.80 37,000 $2,101,600.00 1.127OXY $78.37 16,000 $1,253,920.00 1.361MCD $99.69 21,000 $2,093,490.00 0.650UTX $93.43 18,000 $1,681,740.00 1.120ABT $35.32 30,000 $1,059,600.00 0.684UPS $85.90 19,000 $1,632,100.00 0.888CMCSA $41.98 54,000 $2,266,920.00 1.072MMM $106.31 14,000 $1,488,340.00 0.984CAT $86.97 12,000 $1,043,640.00 1.321HD $69.78 32,000 $2,232,960.00 0.959Portfolio $100,010,954 0.988Power of DiversificationOnly a fraction of the risk associated with anyparticular stock is traced to systematic risks while alarger proportion of the attendant risks may beunsystematic in nature. As such, stock indexfutures generally represent poor hedging vehicles forindividual stocks.However, the CAPM underscores the power ofdiversification. By creating a portfolio of stocks,instead of limiting one’s investment to a singlestock, one may effectively excise, or diversify away,most unsystematic risks from the portfolio. Theacademic literature suggests that one may create an“efficiently diversified” portfolio by randomlycombining as few as 8 individual equities.The resulting portfolio, taken as a whole, may reflectmarket movements with little observable impactfrom those firm-specific risks. That may beunderstood by considering that those unsystematicfactors that uniquely impact upon specificcorporations are expected to be independent onefrom the other.E.g., consider a hypothetical stock portfolio depictedin our table. This portfolio was created using severalof the most heavily weighted stocks included in theS&P 500. The portfolio has an aggregate marketvalue of $100,010,954 as of March 29, 2013.The portfolio’s raw β=0.982 is based on a regressionof weekly returns for a two-year period betweenApril 2011 and March 2013. This implies anadjusted β=0.988. These figures suggest that theportfolio is very slightly conservative and will tend tounderperform the market. Finally, note that itsR2=0.9737, suggesting that 97.37% of itsmovements are explained by systematic marketfactors.Replicating Core or Beta PerformanceWe generally look to a particular stock index toserve as the standard measure, or “benchmark,” or“bogey,” against which the performance of equityasset managers may be measured. The S&P 500stands out as the most popularly referencedbenchmark of U.S. equity market performance. Thisis evidenced by the estimated $6 trillion in equityinvestment that is benchmarked, or bogeyed, orotherwise tied to, the performance of the S&P 500.Asset managers frequently conform their “core”equity holdings to reflect the performance of thebenchmark index, e.g., S&P 500. Subsequently,they may alter the characteristics of the portfolio toseek enhanced return above the core “beta” returnsreflected in the index. Those enhanced returns maybe referred to as “alpha” returns. Strategies in
  11. 11. 10 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPpursuit of this goal are often referred to as“enhanced indexing” strategies.Because stock index futures may be based directlyupon the benchmark utilized by an equity assetmanager, they may be used to replicate theperformance of the benchmark; or, to manage thesystematic risks associated with a well-diversifiedstock portfolio.Stock index derivatives must offer “efficient” or“true” beta to serve as an effective risk-management vehicle. Efficient beta is implicit whenthe contract offers two important attributes including(1) low tracking error; and (2) low transaction costs.This point is a recurring theme in our discussion.Beta Adjustment StrategiesEquity asset manager often seek alpha by adjustingportfolio beta to reflect future market expectations.Thus, an asset manager may diminish portfolio betain anticipation of a bear market; or, increaseportfolio beta in anticipation of a bull market.The former strategy conforms to the textbookdefinition of a “hedge,” i.e., a strategy applyingderivatives to reduce risk in anticipation of adversemarket conditions. While the latter strategy maynot qualify as a textbook hedge – acceptingadditional risk, as measured by beta, in pursuit ofalpha – it is nonetheless equally legitimate.Fund investment policies may permit portfoliomanagers to adjust portfolio beta within a specificrange centered around the beta implicitly associatedwith the benchmark. E.g., one may maintain aβ=1.0 but may be be allowed to adjust beta within arange bounded by 0.80 and 1.20 in pursuit of alpha.Practitioners may identify the appropriate “hedgeratio” (HR), or the number of stock index futuresrequired, effectively to achieve a target riskexposure as measured by beta as follows.Z1 = [LE>FOE − L?DFFO=E] ^_IFE`I@<I;DEDFOAa Where βtarget is the target beta of the portfolio;βcurrent is the current beta of the portfolio;Valueportfolio is the monetary value of the equityportfolio; and, Valuefutures is the nominal monetaryvalue of the stock index futures contract used toexecute the hedge transaction.E.g., assume that the manager of our hypothetical$100,010,954 portfolio believed that the market isovervalued and likely to decline in the near term.Thus, the investor may take steps to reduce betafrom the current 0.988 to 0.900. June 2013 E-miniS&P 500 futures were quoted at 1,562.70 on March29, 2013. This implies a futures contract value of$78,135 (=$50 x 1,562.70). Thus, one might sell113 E-mini S&P 500 futures effectively to reduceportfolio beta from 0.988 to 0.80.Z1 = M0.900 − 0.988P ^ $100,010,954$78,135 a = −113 y = 0.982x - 0.0001R² = 0.9737-8%-6%-4%-2%0%2%4%6%8%10%-8% -6% -4% -2% 0% 2% 4% 6% 8%StockReturnsS&P 500 ReturnsPortfolio v. S&P 500 Wkly Returns(Apr-11 - Mar-13)$65$70$75$80$85$90$95$100$1051,0001,1001,2001,3001,4001,5001,600Apr-10Jul-10Oct-10Jan-11Apr-11Jul-11Oct-11Jan-12Apr-12Jul-12Oct-12Jan-13PortfolioValue(Millions)S&P500Portfolio v. S&P 500S&P 500 Portfolio
  12. 12. 11 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPE.g., assume that the equity manager believed thatthe market is likely to advance and wanted toextend the portfolio beta to 1.10. This requires thepurchase of 143 futures.Z1 M1.100 ( 0.988P ^$100,010,954$78,135a 143Stock index futures may be used to adjust theeffective portfolio beta without disturbing theportfolio’s core holdings. Of course, this process ismost effective when one is assured that futures offerefficient beta with low tracking error and lowtransaction costs.Sell 113 futuresReduces β from0.988 to 0.900Buy 143 futuresIncreases β from0.988 to 1.100Option StrategiesIn addition to offering stock index futures, CME alsooffers options that are exercisable for a variety ofour stock index futures contracts. Options add animportant and flexible element to an equity assetmanager’s risk management toolbox.One may wish effectively to restructure an equityportfolio by augmenting income possibilities,establishing a floor value in addition to simplyreducing risk with the use of futures. These andother possibilities are achievable with the use ofoptions on stock index futures.Covered Call Writing – Assume that an assetmanager holds a stock portfolio and believes thatthe market will be stuck in a neutral holding patternfor the foreseeable future. Under thesecircumstances, the asset manager may wish toengage in a strategy referred to as “covered callwriting” – or to sell call options against the equityportfolio. The call writer or seller is “covered” in thesense that the potential obligation to sell futures onexercise of the options is essentially offset by thelong stock holdings.The short call options will provide the asset managerwith income, through the process of time valuedecay, if the market should remain at current levels.This augments portfolio returns even in anenvironment where the equity prices are static.If the market should decline, the short calls fall out-of-the-money and will be abandoned if held toexpiration by the call buyer. Thus, the call seller orwriter retains the original option price or premium,counting it as income.But if the market should advance, the call options goin-the-money. They will be exercised by the callbuyer, compelling the call seller to sell futures at thestrike or exercise price even though they are tradingat a higher level. The losses that accrue uponexercise are, however, offset by the advancing valueof the stock portfolio. Thus, the covered call writerlocks in a ceiling return in the event of advancingequity values.Sell CallOptionsAugments income in neutralmarket at risk of limitingupside potentialLocking in a Floor – As an alternative to a coveredcall writing strategy, an asset manager may seek topurchase put options. The net effect of this strategyis to create a “floor return” for the stock portfolio.In effect, the put buyer is buying “price insurance”on the value of the portfolio. But this insurancecomes at the cost of the option premium.If prices decline, the put options go in-the-money.The profits that accrue on the put options are,however, offset by the losses associated with thedeclining value of the stock portfolio. Thus, the putbuyer locks in a floor return.If the market should advance sharply, the put buyerbenefits from the advancing value of the stockportfolio. But having paid the option premium,-50-40-30-20-10010203040501,2801,2821,2841,2861,2881,2901,2921,2941,2961,2981,3001,3021,3041,3061,3081,3101,3121,3141,3161,3181,3201,3221,3241,3261,3281,3301,3321,3341,3361,3381,3401,3421,3441,3461,3481,3501,3521,3541,3561,3581,360Profit/LossIndex ValueCovered Call WritingEquity Portfolio Covered Call WritingEquityValuesDeclineEquityValuesAdvance
  13. 13. 12 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPthose profits are reduced by the value of thepremium.Finally, if the market should remain essentiallyneutral, the value of the portfolio remainsunchanged. Still, the put buyer has forfeited theoriginal value of the put options, which serves toreduce the value of the stock portfolio accordingly.Buy putoptionsLocks in “floor return” in bearmarket but limits upside gainsHedging Alternatives – Options serve to increase therange of risk management or hedging alternativesavailable to equity asset managers. But theseinstruments should be deployed judiciously and inconcert with the asset manager’s expectationsregarding possible future market directions.Clearly, a short futures position serves the assetmanager best in a strongly bearish marketenvironment. A covered call writing strategy serveswell in a neutral market. Finally, while the optimalstrategy in a bull market is clearly to remainunhedged, the purchase of put options is the mostattractive of the hedging strategies under thesecircumstances.Bear Market Sell FuturesNeutral Market Sell CallsBull Market Buy PutsIn other words, it behooves the asset manager tocoordinate strategy with a forecast of marketmovements in order to achieve optimal results. Theflexibility of options, as a supplement to futureshedging strategies, provides added dimensions tothe astute manager.Cash EquitizationPassive index investment strategies have becomevery popular over the past 20 years. This isevidenced by the size of the assets undermanagement (AUM) held by passive index mutualfunds as well as the success of various ExchangeTraded Funds (ETFs), including SPDRs (“SPY”) andothers designed to replicate the performance of theS&P 500.Mutual funds typically offer investors the opportunityto add or withdraw funds on a daily basis. As such,equity managers are often called upon to deployadditions or fund withdrawals on short notice. Theycould attempt to buy or sell stocks in proportionsrepresented by the benchmark. But execution skidsor slippage may cause fund performance to sufferrelative to the benchmark.Or, they can utilize stock index futures as atemporary proxy for the addition or withdrawal offunds. I.e., buy futures effectively to deployadditions of capital; sell futures to coverwithdrawals. This “cash equitatization” strategyprovides the equity asset manager with time tomanage order entry in the stock market whilemaintaining pace with the benchmark.Some asset managers may utilize futures as a long-term proxy for investment in the actual stockscomprising the index to the extent that the leverage-50-40-30-20-10010203040501,2801,2821,2841,2861,2881,2901,2921,2941,2961,2981,3001,3021,3041,3061,3081,3101,3121,3141,3161,3181,3201,3221,3241,3261,3281,3301,3321,3341,3361,3381,3401,3421,3441,3461,3481,3501,3521,3541,3561,3581,360Profit/LossIndex ValueBuying Put ProtectionEquity Portfolio Put ProtectionEquityValuesDeclineEquityValuesAdvance-50-40-30-20-10010203040501,2801,2821,2841,2861,2881,2901,2921,2941,2961,2981,3001,3021,3041,3061,3081,3101,3121,3141,3161,3181,3201,3221,3241,3261,3281,3301,3321,3341,3361,3381,3401,3421,3441,3461,3481,3501,3521,3541,3561,3581,360Profit/LossIndex ValueHedging AlternativesEquity Portfolio Futures HedgeCovered Call Writing Put ProtectionEquityValuesEquityValues
  14. 14. 13 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPassociated with futures frees up capital forredemptions or distributions.Buy futures To deploy new capital additionsSell futuresTo cover capital withdrawalsor distributionsConsistent with our recurring theme, the successfulexecution of cash equitization strategies isdependent upon the degree to which futures deliverefficient beta, i.e., low tracking error and lowtransaction costs.Long-Short StrategiesThere are many strategies deployed in the equitymarkets involving a combination of long and shortpositions designed to create alpha returns.One of the most common of long/short strategies isknown simply as “130/30.” 6The equity managerbegins by distinguishing stocks that are expected togenerate superior returns vs. those that areexpected to generate inferior average returns.Thus, the asset manager could distinguish superiorfrom inferior stocks by rank ordering all theconstituents of the S&P 500 from best to worstbased on some selection criteria. The manager buysthe superior stocks with 130% of the fund’s AUM,funding the excess 30% long position byshorting/selling inferior stocks valued at 30% ofAUM. 7To the extent that the fund’s goal is often stated asoutperforming the S&P 500, core fund holdings maymimic the holdings of the S&P 500. I.e., one maydeploy 100% of AUM in stocks or derivatives thatmimic the benchmark index. Frequently, stock6130/30 strategies probably evolved from a populartechnique known as “pairs trading.” This requires oneto identify pairs of corporations, typically engaged in thesame or similar industry sectors. E.g., one may pair 2high-tech computer companies, 2 energy companies, 2auto companies, etc. One further identifies the strongerand weaker of the 2 companies in each pair, based uponfundamental or technical analysis, buying the strongerand selling the weaker company in each pair. Byexecuting this strategy across multiple pairs of stocks,one may hope to generate attractive returns.7There is nothing particularly magical about the 130/30proportion. Sometimes the strategy is pursued on a140/40 ratio, sometimes on a 120/20 ratio, or with theuse of other proportions.index futures are deployed to generate those core orbeta returns.A core beta investment created with stock indexfutures provides fund managers with flexible cashmanagement capabilities including the ability todeploy additions or fund withdrawals quickly andefficiently. But, again, this strategy is only effectiveprovided that futures offer efficient beta.Buy-and-holdfuturesReplicate core or beta portfolioperformance with cashmanagement flexibilitySector Rotation StrategiesEquity asset managers will generally allocate theirfunds across stock market industry sectors andindividual stocks. In many cases, they may conformthe composition of the portfolio to match that of thebenchmark or bogey. This strategy assures that theperformance of the portfolio generally will parallelperformance of the benchmark.E.g., the Standard & Poor’s 500 is the mostpopularly referenced benchmark for U.S. equityasset managers. It is comprised of securities drawnfrom ten well defined industry sectors as indicatedbelow.However, asset managers may subsequently re-allocate, or rotate, portions of the portfolio amongstthese various sectors in search of enhanced value.E-mini S&P Select Sector Stock Index futuresprovide the basis for an “overlay” strategy whichmay be deployed effectively to rotate assets fromLongS&P 500futuresnotionallyvalued @100%of AUMLongSuperior stocks@ 30% of AUMShortInferior stocks@ 30% of AUM130/30 Strategy with Futures
  15. 15. 14 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPone market sector to the next without disturbing thecomposition of the underlying cash or spot equityportfolio. This entails a relatively simple strategy ofshifting away from low beta into high beta sectors inanticipation of a bull market in equities. Or, shiftingaway from high beta and into low-beta sectors inanticipation of a bear market.While all of S&P Select Sector indexes are positivelycorrelated to the “mother” S&P 500 Index, the betas(β) and coefficients of determination (R2) derivedfrom a statistical regression of sector index returnsvs. those of the S&P 500 vary widely.Select Sector Performance vs. S&P 500(Based on Weekly Data from 4/29/11 – 4/26/13)Index Symbol Beta (β) R2Consumer Disc IXY 1.039 0.911Consumer Staples IXR 0.526 0.664Energy IXE 1.354 0.857Financial IXM 1.298 0.895Health Care IXV 0.734 0.810Industrial IXI 1.156 0.943Materials IXB 1.258 0.834Technology IXT 1.002 0.878Utilities IXU 0.442 0.424Source: BloombergE.g., the utility index exhibits a conservative beta of0.442 and a weak correlation of 0.424. The energyand financial indexes have very aggressive betas of1.354 and 1.298, respectively. The industrial sectoris most heavily correlated with the S&P 500 with anR2=0.943.By early 2013, the economy seems to be showingsigns of recovery and the stock market has rallied tonew all-time highs. Thus, the financial sector of themarket has rallied back from the lows to which itsank in the wake of the subprime crisis which brokeout in 2007-08. If an asset manager expected thistrend to continue, he might consider rotating thecomposition of the portfolio from industrials intofinancials.This may be accomplished simply by liquidatingindustrial stocks in favor of buying financial stocks.Or, one might utilize Select Sector futures similarlyto restructure the portfolio. Specifically, one maytransact a spread by selling E-mini Industrial SelectSector futures and buying E-mini Financial SelectSector futures. In fact, this strategy is analogous tothe spreading strategy discussed above with thedistinction that this spread may be executed in thecontext of a risk management or investmentstrategy rather than as a purely speculative pursuit.In order to place an inter-market spread, it isnecessary to derive the so-called “spread ratio” asdiscussed above. Let us further borrow the detailsof our spreading example as well.E.g., on July 16, 2012, the September 2012Financial/Industrial spread ratio was calculated at1.062, suggesting that one might balance 20Financial index futures with 21 Industrial indexfutures, or a similar ratio.Assume that manager of the $100,010,954 portfoliowanted to “overweight” financials by 5% andsimilarly “underweight” industrials by 5%. Thiswould imply the purchase of 137 Financial Sectorfutures [= (5% x $100,010,954) ÷ $36,537.50])coupled with the sale of 145 Industrial Sectorfutures (=1.062 x 137).Buy 137 FinancialSector futures &Sell 145 IndustrialSector futuresEffectively over-weightsfinancials by 5% &under-weightsindustrials by 5%Thus, our asset manager may quickly and effectivelyrotate investment from one economic sector toanother while leaving core holdings undisturbed.Similarly, one may use stock index futures to rotateinvestment from one national stock market toanother.E.g., one might sell CME E-mini S&P 500 futures andbuy CME E-mini S&P CNX Nifty futures effectively torotate investment away from U.S. and into Indianequity markets.Conditional RebalancingTraditional pension fund management strategiesrequire investors to allocate funds amongst differentasset classes such as stocks, bonds and “alternate”investments (e.g., real estate, commodities). Atypical mix may be approximately 60% in stocks;30% in bonds and 10% in alternative investments.The mix may be determined based on investorreturn objectives, risk tolerance, investment horizonand other factors.
  16. 16. 15 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPAfter establishing the allocation, investors oftenretain the services of active fund managers tomanage portions of portfolio, e.g., stocks, bonds,etc. Thus, investors may seek to retain managers inhopes of generating excess return (or “alpha”)beyond the beta return in any specific asset classes,as measured by benchmark indexes, e.g., S&P 500in equity markets; or, Barclays Capital U.S.Aggregate Index in the bond markets.But the portfolio’s mix will necessarily fluctuate as afunction of market movements. E.g., if equitiesadvance (decline) sharply, the portfolio may becomeover (under) weighted with stock; and, under (over)weighted with bonds. As such, the portfoliomanager may be compelled to rebalance theportfolio by reallocating funds from one asset classto another.Sometimes asset managers use options on E-miniS&P 500 futures to provide for a “conditionalrebalancing” of the portfolio. Specifically, one mightsell call options and put options in the form of anoption strangle, i.e., sell out-of-the-money calls andsell out-of-the-money puts.If stocks rally beyond the strike price of the calloptions, they may be exercised, resulting in shortfutures positions. Those short futures contracts willserve effectively to offset expansion of the equityportion of the portfolio if the market continues toadvance; or, as a hedge if the market shouldreverse downward.Sell out-of-the-money calls & puts(sell a strangle)Rebalances position,creating long futurespositions in bear market &short futures in bull marketIf stocks decline beyond the put option strike price,they may likewise be exercised, resulting in a longfutures position. That long futures position servesas a proxy for the further purchase of equities.Portable Alpha“Portable alpha” investment strategies have becomequite popular over the past decade. This techniquedistinguishes total portfolio returns by reference toan alpha and a beta component. The betacomponent of those returns is tied to a generalmarket benchmark, e.g., the S&P 500. Additionalreturns are generated by devoting a portion of one’sassets to another more ambitious trading strategyintended to generate a superior return over the baseor benchmark “beta” return.Why has the market embraced portable alphaprograms? Consider the traditional or typical assetallocation approach practiced by many pension fundmanagers. This process generally involves allocationof a specified proportion of one’s assets to variousasset classes, often facilitated by the employment ofexternal asset managers. E.g., it is quite commonto allocate roughly 60% of one’s assets to stocks,30% to bonds and the residual 10% to alternateinvestments possibly including real estate,commodities and other items.While this approach is typical, it may nonethelessfail to generate returns in excess of benchmarkreturns. In particular, few asset managers are ableconsistently to outperform the market afterconsidering management fees. If they did, theirservices would be in much demand and highmanagement fees may detract from performance.Portable alpha strategies are designed specifically inthe hopes of achieving (alpha) returns in excess ofthe applicable benchmark (or beta) returns. Thus,there are two components of a portable alphastrategy: alpha and beta.Beta is typically created with a passive buy-and-holdstrategy using derivatives such as futures or over-the-counter swaps. Stock index futures have provento be particularly useful vehicles for achieving thoseStocks62%Bonds 29%AlternateInvest-ments9%Typical Exposure of S&P 500Defined Benefit Pension FundSource: Credit Suisse Asset Mgt, “Alpha ManagementRevolution or Evolution, A Portable Alpha Primer,”
  17. 17. 16 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPbeta returns in the context of a portable alphaprogram. Futures are traded on leverage, freeing asizable portion of one’s assets for application to analpha generating strategy. Per our recurring theme,futures must offer efficient beta to serve theirpurpose, a point discussed in more detail below.Buy-and-holdfuturesReplicate core or betaportfolio performancewith cash managementflexibilityAlpha returns, in excess of prevailing short-termrates as often represented by LIBOR, are generatedby applying some portion of one’s capital to anactive trading strategy. Common alpha generatingstrategies include tactical asset allocation or“overlay” programs that attempt to shift capital fromless to more attractive investments; programs thatattempt to generate attractive absolute returns suchas hedge funds, commodity funds, real estateinvestment vehicles; and, traditional activemanagement strategies within a particular assetclass or sector of an asset class. Much of the growthin the hedge fund industry in recent years may beattributed to the pursuit of alpha.Of course, more active alpha generating strategiestend to require more trading skill. While they maygenerate attractive returns, they may also entailhigher management fees. And still, it is difficult tofind an investment strategy that consistentlydelivers attractive alpha and that is truly distinctfrom the benchmark class that forms the core betareturns.As such, the major and most obvious risk associatedwith portable alpha strategies is the possibility thatthe alpha strategy fails to outperform LIBOR.Still, it is safe to conclude that the “search for alpha”will continue unabated in the future. This isapparent when one considers the significant pensionfunding gap, or the difference between pension fundassets and the present value of their futureobligations. As of the conclusion of 2011, the gapfaced by the corporate pension funds of the firmsthat comprise the S&P 500 stood at some $355billion.Delivering Efficient BetaA recurring theme in this discussion is that stockindex futures must deliver efficient beta, i.e., lowtracking error and low transaction costs, in ordereffectively to serve the purposes as outlined above.01,0002,0003,0004,0005,0006,0007,0008,0009,000$0$400$800$1,200$1,600$2,000$2,400199719981999200020012002200320042005200620072008200920102011Q312No.ofHedgeFundsAssetsUnderMgt(Bil)Size of Hedge Fund Industry# of HFs (ex-FoFs) Assets Under MgtSource: Hedge Fund Research-39%-26%-13%0%13%26%39%-400-300-200-1000100200300199819992000200120022003200420052006200720082009201020112012S&P500TotalReturnPensionFunding(Billions)Pension Funding Gap vs. S&P 500Pension Funding Status S&P 500 Total ReturnSource: Standard & PoorsAlphaCreate returns> LIBOR thruactive tradingBetaCapture core orbeta returns bypassivelyholding S&P500 futures orotherderivativesPortable Alpha StrategyAlphaCreate returns> LIBOR thruactive tradingTransportingAlpha
  18. 18. 17 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPLow tracking error means that the futures contractaccurately and consistently reflects its “fair value.”This is reflected in the end-of-day (EOD) mispricingsor deviations between the futures settlement priceand fair value as reflected in the spot index valueadjusted by financing costs and anticipateddividends.Note that CME Group utilizes an end-of-month fairvalue (FV) settlement procedure. This means thaton the final day of each calendar month, the futuressettlement prices for many CME Group domesticstock index futures are established by reference toits fair value.The Exchange surveys broker-dealers for theapplicable interest rate and anticipated presentvalue of dividend flows and calculates the fair valueof the futures contract. Thus, these CME Groupstock index futures are forced to reflect fair value atthe conclusion of each calendar month or accountingperiod. This practice has likely contributedsignificantly to the growth of the portable alpha fundbusiness since 1998 when the practice wasestablished.A further means of measuring tracking error is byreference to the “roll” or the difference betweenprices prevailing between the current and deferredfutures contract month. Portable alpha managerstypically use stock index futures on a passive buy-and-hold basis. Thus, they establish a long positionand maintain it consistently in proportion to theirAUM. But they will roll the position forward, i.e., sellthe nearby, maturing contract in favor of buying adeferred contract, on a quarterly basis.Independent research on the subject of end-of-daymispricing and mispricing inherent in the quarterlyroll suggests that CME Group products are quitecompetitive relative to stock index futures offeredelsewhere.Transaction costs attendant to trading stock indexfutures may be comprised of various componentsincluding brokerage commissions and exchangefees. But the most significant of transaction costs istrading friction, aka execution skids or slippage, i.e.,the risk that the market is insufficiently liquid toexecute commercial-scale transactions at fair prices.Liquidity may be measured in many ways but two ofthe most common and practical methods are tomonitor the width of the bid-ask spread; and, thedepth of market.The width of the bid-ask spread simply refers to theaverage difference between the bid and the askingor offering price throughout any particular period.These figures may be based upon order sizes ofstated quantities, e.g., a 50-lot, a 100-lot order, etc.Liquidity is correlated closely with volatility.The VIX or S&P 500 volatility index is a popularmeasure of volatility. The width of the bid-askspread widened in late 2008 and early 2009 at theheight of the so-called subprime mortgage crisiswhen the VIX advanced to 60%. Since then,market width has declined to levels barely over the-30-20-10010203040E-miniS&P500E-miniNasdaq-100E-miniMidCapE-mini($5)DJIAICERussell2000BrazilBovespaMexicoBolsaIdxDJEuroSTOXXFTSE100DAX30Nikkei225(OSE)TOPIXHangSengKospi200TAIEXS&PCNXNiftyMSCIEAFEMSCIEMBasisPointsAverage End-of-Day Mispricing(3 Months ending Mar-13)Source: GS Futures Focus MonthlyCME GroupProducts-200-150-100-50050100150E-miniS&P500E-miniNasdaq-100E-miniMidCapE-mini($5)DJIAICERussell2000BrazilBovespaMexicoBolsaIdxDJEuroSTOXXFTSE100DAX30Nikkei225(OSE)TOPIXHangSengKospi200TAIEXS&PCNXNiftyMSCIEAFEMSCIEMBasisPointsCalendar Spread Mispricing(3 Months ending Mar-13)Source: GS Futures Focus MonthlyCME GroupProducts
  19. 19. 18 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPone minimum price fluctuation ($12.50) in E-miniS&P 500 futures for a 500-lot order.Market depth is a reference to the number of restingorders in the central limit order book (CLOB). TheCME Globex® electronic trading platform routinelydisseminates information regarding market depth atthe best bid-ask spread (the “top-of-book”), at the2nd, 3rd, 4thand 5thbest bid and asking prices aswell. Liquidity as measured by market depth hasincreased significantly since the recent financialcrisis.Concluding NoteCME Group is committed to finding effective andpractical risk-management solutions for equity assetmanagers in a dynamic economic environment.While the recent financial crisis has sent shiversthrough the investment community, it is noteworthythat CME Group’s exchange traded futures andoptions on futures performed flawlessly throughoutthese trying times. Our products offer deepliquidity, unmatched financial integrity andinnovative solutions to risk management issues.10%20%30%40%50%$10$15$20$25$30$35$40Jul-09Nov-09Mar-10Jul-10Nov-10Mar-11Jul-11Nov-11Mar-12Jul-12Nov-12Mar-13CBOEVIXIndexBid-Askin$sperContractE-Mini S&P 500 Market WidthLead Month on CME Globex RTHS&P 500 VIX Index 50 Cnt Width100 Cnt Width 200 Cnt Width500 Cnt Width 1,000 Cnt Width0500,0001,000,0001,500,0002,000,0002,500,0003,000,0003,500,0004,000,00002,0004,0006,0008,00010,00012,000Jul-09Dec-09May-10Oct-10Mar-11Aug-11Jan-12Jun-12Nov-12AvgDailyVolumeDepthinContractsE-Mini S&P 500 Market DepthLead Month on CME Globex RTHTop-of-Book Qty 2nd Level Qty3rd Level Qty 4th Level Qty5th Level Qty Avg Daily Volume
  20. 20. 19 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPExhibit 1: Specifications of Popular Stock Index Futures ContractsE-mini S&P 500 E-mini Nasdaq 100 E-mini MidCap 400 E-mini ($5) DJIAContact multiplier$50 ×S&P 500 Index$20 ×Nasdaq 100 Index$100 ×S&P MidCap 400$5 × Dow JonesIndustrial AverageMinimum pricefluctuation (tick)0.25 index points($12.50)0.50 index points($10.00)0.10 index points($10.00)1.00 index points($5.00)Price limits Limits at 7%, 13%, 20% movesContract months First five months in March quarterly cycleFirst four months inMarch quarterly cycleTrading hours Mon–Thu: 5:00 PM (previous day) to 4:15 PM with trading halt between 3:15 PM and 3:30 PMTrading ends at 8:30 AM on third Friday of monthCash settlement Vs. Special Opening Quotation (SOQ)Position limits oraccountability100,000 E-miniS&P contracts50,000 E-miniNASDAQ contracts25,000 E-miniMidCap contracts100,000 E-miniDJIA contractsSymbol ES NQ EMD YMExhibit 2: Quoting E-mini S&P 500 Futures(As of 4/23/13)Month Open High Low Settlement Change VolumeOpenInterestJun-13 1,557.25 1,527.00 1,548.75 1,573.60 +17.70 2,108,113 2,984,052Sep-13 1,550.25 1,570.50 1,543.00 1,567.60 +17.80 14,452 41,661Dec-13 1,549.25 1,563.50 1,536.50A 1,561.10 +17.80 60 2,438Mar-14 1,532.50 1,555.00B 1,530.25A 1,554.90 +17.80 10 27Jun-14 1,544.25B 1,529.25A 1,547.90 +17.80 1TOTAL 2,122,635 3,028,179
  21. 21. 20 | Understanding Stock Index Futures | May 3, 2013 | © CME GROUPExhibit 3: Pricing Popular Stock Index Futures(As of 4/23/13)ContractMultiplierJun-13ContractContractValueTick(IndexPoints)$ Value ofTickStandard S&P 500 $250 x 1,573.60 $393,400 0.10 $25.00E-mini S&P 500 $50 x 1,573.60 $78,680 0.25 $12.50E-mini Nasdaq 100 $20 x 2,823.00 $56,460 0.50 $10.00E-mini S&P MidCap 400 $100 x 1,133.80 $113,380 0.10 $10.00E-mini ($5) DJIA $5 x 14,644 $73,220 1.00 $5.00Copyright 2013 CME Group All Rights Reserved. Futures trading is not suitable for all investors, and involves the risk of loss. Futures are a leveraged investment, and because only apercentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited for a futures position. Therefore, traders should only use funds that theycan afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one trade because they cannot expect to profit on every trade. All examples inthis brochure are hypothetical situations, used for explanation purposes only, and should not be considered investment advice or the results of actual market experience.”Swaps trading is not suitable for all investors, involves the risk of loss and should only be undertaken by investors who are ECPs within the meaning of section 1(a)18 of the CommodityExchange Act. Swaps are a leveraged investment, and because only a percentage of a contract’s value is required to trade, it is possible to lose more than the amount of money deposited fora swaps position. Therefore, traders should only use funds that they can afford to lose without affecting their lifestyles. And only a portion of those funds should be devoted to any one tradebecause they cannot expect to profit on every trade.CME Group is a trademark of CME Group Inc. The Globe logo, E-mini, Globex, CME and Chicago Mercantile Exchange are trademarks of Chicago Mercantile Exchange Inc. Chicago Board ofTrade is a trademark of the Board of Trade of the City of Chicago, Inc. NYMEX is a trademark of the New York Mercantile Exchange, Inc.The information within this document has been compiled by CME Group for general purposes only and has not taken into account the specific situations of any recipients of the information.CME Group assumes no responsibility for any errors or omissions. Additionally, all examples contained herein are hypothetical situations, used for explanation