Chapter 04

STOCK INDEX FUTURES CONTRACTS:
ANALYSIS AND APPLICATIONS
CHAPTER 4
Chapter Objectives
• This Chapter intends to study Stock Index Futures (SIF) in depth with emphasis on
FBM KLCI Futures Contract.
• On completion of this chapter you should have the understanding of how SIF are used
for hedging, speculation and arbitrage activity.
• You should also have good knowledge of recently introduced Single Stock Futures
(SSF).
• You should have an understanding of the application of SIF and SSF.
CHAPTER 4: STOCK INDEX FUTURES CONTRACTS: ANALYSIS AND APPLICATIONS Copyright © 2017 by McGraw-Hill Education (Malaysia) Sdn. Bhd. 3
Stock Index Futures Contract (SIF)
• A 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.
• Example: Dow Jones is an index comprising 30 stocks traded on New York Stock Exchange.
• A SIF contract entitles the holder to ‘take delivery’ of the group of stocks that make up
the index at a pre-specified price and at a pre-determined future date.
• All SIF contracts are cash settled contracts.
• The need for cash settlement arises from the fact that physical delivery of the group of stocks
that make up an index would be very cumbersome and costly.
• First SIF was introduced in 1982 by Kansas City Board of Trade on the Valueline Index.
• FTSE Bursa Malaysia Kuala Lumpur Composite Index Futures was launched on 15
December, 1995.
• The Kuala Lumpur Composite Index (KLCI) is an index of 30 stocks traded on the KLSE
• This SIF contract was Malaysia’s first financial derivative, and probably Asia’s only
emerging market SIF contract.
Table 4.0: Top Ten SIF contracts by traded volume – 2014
Rank SIF Name Exchange
1 E-mini S&P 500 futures Chicago Mercantile Exchange
2 EURO STOXX 50 Index Futures Eurex
3 RTS Index Futures Moscow
4 CSI 300 Futures China Financial Futures Exchange
5 Nikkei 225 Mini Osaka Exchange
6 E-Mini NASDAQ 100 Futures Chicago Mercantile Exchange
7 Nifty Futures National Stock Exchange- India
8 BIST 30 Index Borsa Istanbul –Turkey
9 SGX FTSE China A50 Index Futures Singapore Stock Exchange

10 Mini Dow Jones Index Chicago Mercantile Exchange
Source: WFE/IOMA 2014 Derivatives Market Survey.
• Why Use SIF Contracts?
• Diversification Benefits
• Diversification benefits refer to reduction in risk as one diversifies across assets.
• This diversification benefit in SIF arises from the underlying portfolio of stocks which
constitutes the index. Thus, purchasing a SIF contract is akin to buying each of the component
stocks in the index.
• According to Portfolio theory, investment in a broad range of stocks reduces unsystematic

risk.
• Lower Transaction Cost

• Several factors contribute to the lower transaction costs.
• Brokerage costs like commissions are lower on a percentage of face value basis.
• The margins that need to be posted for SIF contracts are also much lower relative to full payment
on stock purchase
• Transaction costs to buy each and every single stock in the index separately are much higher than
buying the stock index future.
• Provides Leverage
• Margins in SIF transactions means investment outlays that are much lower than transactions
in the stock market.
• It implies that there would be automatic leverage with SIF contracts.
• This diversification benefit in SIF arises from the underlying portfolio of stocks which
constitutes the index. Thus, purchasing a SIF contract is akin to buying each of the component
stocks in the index.
• According to Portfolio theory, investment in a broad range of stocks reduces unsystematic

risk.
• Market Exposure and Stock Selection

• A position in SIF contracts allows for exposure to the entire market, that is exposure to broad
based market movements.
• Example: Suppose an American mutual fund manager is bullish about the Malaysian economy and
wants exposure to Malaysian stocks. He gets instant exposure to the overall market by going long a
FBM KLCI futures contract.
• In the absence of SIF contracts, the foreign fund manager would have to engage in individual stock
selection to assemble a portfolio of Malaysian stocks
• SIF contracts offer broad market exposure, and are suitable for passive investment
strategies
• Hedging, Portfolio Insurance and Risk Management

• There are two ways in which SIF contracts are particularly suited for hedging purposes:
• Managing Systematic Risk:

• Systematic risk is the risk that remains even after one has put together a broad portfolio of assets.
• An investor can eliminate all unsystematic risk through diversification but would still be faced with
systematic risk
• Hedging the Overall Value of a Portfolio:

• SIF contracts provide a very effective, easy and low cost method by which equity exposure could be
hedged.
Types of Indexes
• A stock index is essentially a barometer of stock market performance.
• Indexes are essentially statistical sampling. There are three types of stock indexes:
• Equally weighted (price weighted) index;
• Value weighted (capitalization weighted) index
• Geometrically weighted index
• Each method of computation has its own advantages and disadvantages.
Types of Indexes
• Equally Weighted Index
• It is computed by adding the closing prices of the component stocks and dividing by a divisor.
• Example: Dow Jones Industrial Average (DJIA), Major Market Index (MMI) and Nikkei 225
Types of Indexes
• Equally Weighted Index
• It is computed by adding the closing prices of the component stocks and dividing by a divisor.
• In a price weighted index, every stock has equal weight.
• Since every stock has equal weight, it has ‘equal influence’ on the index’s closing value.
• Because an index should be representative, small companies are often also included.
Types of Indexes
• Capitalization Weighted Index
• 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.
• Market value or market capitalization refers to the price per share multiplied by the number of
shares outstanding.
• A capitalization weighted index gives a larger weight to big firms which have a large number
of shares outstanding.
Types of Indexes
• Capitalization Weighted Index
• In a capitalization weighted index, each component stock has a different weight in the
calculation.
• Example: S&P 500, TOPIX, FBM KLCI
Types of Indexes
• Capitalization Weighted Index - Examples
• Suppose there are three stocks in the Index and computation begins on day 1.
Types of Indexes
• Capitalization Weighted Index - Examples
• Suppose there are three stocks in the Index and computation begins on day 1.
• On day 2, the index would be reported to have gone up 2.29 points.
• In a capitalization weighted index, larger capitalized firms would have more influence
Types of Indexes
• Geometrically Weighted Index
• It is neither common nor very popular method.
• It is a difficult method to replicate for index calculations.
• Example : Valueline index
Futures Contract Specification
• Contract specifications are 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.
• It is to ensure fairness to all parties involved and a clear and transparent process in
settlement, margining, etc.
• FBM KLCI Futures Contract
• FBM KLCI Futures Contract - Features
• The contract size is the FBM KLCI multiplied by RM 50. This RM 50 is known as the index
multiplier.
• The Minimum Price Fluctuation is also known as tick size. A tick size of RM 25 means that a
buyer willing to offer a higher price than currently prevailing, must bid at least RM 25 higher.
• Daily Price Limits determine the extent to which prices can fluctuate in any given trading
session.
• A 20% price limit means that prices can go up or down a maximum 20% over the previous close
price.
• Contract Months, tells us the fixed maturity periods of the contracts.

• As per the contract specification, four FBM KLCI futures contracts would be available for trading
any one time.
• Trading Hours of the futures contract are the available time slots for trading.
• The trading for FBM KLCI begins 15 minutes before the stock market (Bursa Malaysia) opens and
ends 15 minutes after the Bursa closes in each session.
• The delayed closure of futures trading hours is to enable fund managers and other institutions to
hedge out whatever net positions that may have resulted from the day’s trading and which the
fund manger may not wish to carry overnight.
• Final Settlement Value of the contract at maturity is determined by averaging the value of the
index for the 30 minute period.
• The need to use such an averaging process is to eliminate the possibility of last minute market
manipulation influencing final settlement values.
• Transaction Costs for FBM KLCI Futures used to be RM 60 but now is usually negotiable with
large trades.
• Example: Assume the FBM KLCI is now at 1,000 points
• A RM 50,000 position established in the futures market has a transaction cost of RM 30 or 0.06
percent.
SIF Trading – The Main Players
• Main players in SIF markets are institutional investors largely due to the large money
amounts involved in SIF trading.
• For FBM KLCI futures contracts, the multiplier is RM 50. This means that a single contract
would be worth in excess of RM 50,000 if the FBM KLCI is above 1,000 points.
• Since the exposures are huge, there are very few retail or individual players in SIF
contracts.
• The main players would therefore be institutions like Pension Funds, Insurance
Companies, Fund Management, Merchant Banks, Asset Management companies,
Mutual Funds, etc.
Pricing of SIF Contracts
• Cost of Carry (COC) Model for Futures contract is:
• Unlike the commodity futures contract, two adjustments to COC model would be
required.
• The storage/handling cost of financial futures contracts like SIF is practically zero. Thus, the
variable ‘c’ drops off from the equation.
• Since holding a portfolio of stocks would enable one to receive any dividends declared, the
variable y can be replaced with d, to denote the dividend yield.
• Example:
• Assume the following:
• The spot index, the FBM KLCI is now 960 points;
• the average annual dividend yield of the FBM KLCI is 2%
• The risk free interest rate is 6% annualized;
• index multiplier is RM 50.
• What would be the correct price of a SIF contract if it matures in

• 3 months,
• 6 months
• 1 year?
• Example:
• 3 months,
• 6 months
• 1 year?
• The correct price/fair value in points of a 3-month FBM KLCI futures contract is 969.46 points.
• Since the index multiplier is RM 50; thus, 969.46 points × RM 50 Ringgit value per contract = RM
48,473.00
• Example:
• 3 months,
• 6 months
• 1 year?
• The equilibrium price of a 6-month FBM KLCI futures contract is 979.01 points.
• Ringgit value = 979.01 points × RM 50 = RM 48,950.50
• Example:
• 3 months,
• 6 months
• 1 year?
• The fair value of a 1-year FBM KLCI futures contract is 998.40 points.
• Ringgit value = 998.40 × RM 50 = RM 49,920.00
• Dividend Yields and Dividend Payment Patterns
• From previous calculations it is observed that the futures price increases as the futures
maturity gets longer.
• he reason for this is that the net carrying cost (rf – d) gets compounded for a longer period as
the maturity increases.
• For the six-month futures, the net carrying cost is approximately 2%, whereas for the full year
maturity it is 4%.
• The futures price will always be higher than spot when the net carrying is positive. However, if
the net carrying cost is negative, then the futures price would be less than the spot price.
• The net carrying cost be negative due to the fact that dividend payments tend to be ‘lumpy’.
• Dividend patterns that tend to be clustered can result in negative net carrying and
SIF prices being lower than spot value
• This clustering has to do with the fact that most companies pay dividends twice a year, an
interim dividend and a final dividend. As most companies have end December as their
fiscal year end, the declared final dividend gets paid typically in March.
Applications of SIF Contracts
• Index Arbitrage
• Index arbitrage is the process of arbitraging between SIF and the spot market.
• 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.
• To take advantage of this ‘mispricing’, 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 do the following. Long the futures contract, and short the spot market.
• Index Arbitrage
• The arbitrage here is riskless since there is no net exposure; further the arbitrage should
require no net cash outflows.
• That is, the arbitrage strategy should self finance such that the arbitrageur has no out-of-pocket
outlays.
• The size of the arbitrage profit will depend entirely on the extent of mispricing.
• Underlying market movements will have no bearing on the profit.
• Suppose following information is given

• 3-month SIF price = 1,210
• Index value = 1,200 points
• rf rate = 4%
• Dividend yield = 2%
• Time to maturity of SIF = 90 days
• Index Arbitrage - Example
• The correct value of the 3-month SIF should be:
• This shows 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 and is overpriced by approximately 4 points.
• Since there is mispricing, arbitrage is possible.
• Assume the following two possible scenarios

• Index rises to 1225 at maturity.
• Index falls to 1175 at maturity.
• Scenario 1
• Scenario 2
• Index Arbitrage – Example
• Whether the index went up or down, Profit of RM 211.80 of profit.
• This proves that the arbitrage profit is independent of market performance.
• The arbitrage profit which is 0.35% (RM211.80/RM60,000) approximates the percentage

deviation in the actual futures price from theoretical price. [(1210 –1205.96) × 50]/60,000 =
0.34%.
• The size of the arbitrage profit is determined by extent of the mispricing.
• Index Arbitrage – Example 2
• Suppose in the previous example, the futures price today is quoted as 3-month SIF price = 1201.
• The SIF is underpriced relative to spot.
• Index Arbitrage – Example 2
• Suppose in the previous example, the futures price today is quoted as 3-month SIF price = 1201.
• The SIF is underpriced relative to spot.
• Hedging
• SIF are used for hedging equity exposures by fund managers.
• Example: A fund manger has exposure to Malaysian stocks and intends to keep his position in
the stocks since he thinks the underlying fundamentals are good. However, he is worried
about volatility that could erode the current value of his portfolio. How can he use SIF to
Hedge?
• The following information is available to you today.
• Current value of portfolio = RM 1,200,000
• rf rate = 6% per year
• Dividend 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.)
• Hedging - Example
• The fund manager has a long position in stocks, hedging would require that to establish an
offsetting short position in SIF contracts. But how many SIF Contracts should he short? The
answer depends on how closely the portfolio is correlated to the market index. If it exactly
tracks the FBM KLCI, then he can do a base hedge.
• According to base hedge he can short 20 SIF contracts.
• The fund manager beta of portfolio is 1.20. The number of contracts he requires to hedges is
calculated via the following two methods.
• Established on this. The fund manager goes short 24 contracts in SIF.
• Analysis of Hedged Position
• Creating Synthetic Position (Replication)
• Suppose in the earlier example, the fund manager had liquidated the portfolio of
RM1,200,000 and invested the cash in a risk free asset; he would have earned an annualized
return equal to 6%. Since he also earned approximately the risk free return with the hedged
portfolio, he has essentially created a synthetic cash position.
• Long futures ⇒ we pay premium of 4%; (0.06 – 0.02) (rf – d)

Short futures ⇒ we receive premium of + 4% (0.06 – 0.02) (rf – d)
• Long stock portfolio ⇒ we receive the dividend yield; +0.02 or 2%

Short stock portfolio ⇒ we pay the dividend yield; 0.02 or 2%
• Creating Synthetic Position (Replication)
• Recall that the hedge above involved the following: short futures and long (hold) stock
portfolio.
• When shorting futures, he received the 4% premium; then in holding the stock portfolio, he
received the 2% dividend yield. Together it adds up to the 6% risk free rate.
• Speculation
• A speculative position is simply establishing a position in the SIF market without any offsetting
position in the underlying stocks/index.
• Bullish Expectation: Illustration
• Suppose a speculator believes that the remaining four trading days of the week is likely to see an
increase in the stock market index and SIF contract value.
• The appropriate speculative strategy would be to long the SIF contract.
• Speculation
• Bullish Expectation: Illustration
• Suppose a speculator believes that the remaining four trading days of the week is likely to see an
increase in the stock market index and SIF contract value.
• The appropriate speculative strategy would be to long the SIF contract.
• The speculator had been correct in his expectation. Since the index was up 14 points from initial
value, he gets an accumulated profit of RM 700. (14 points × RM 50).
• The profit could also have been determined as: (Exit Value – Entry Value) × Multiplier = (1214 –
1200) × RM 50 = RM 700.
• Since the speculative position has no offsetting position, someone who had been bearish and gone
short on day 0 would have lost RM 700
• Speculation
• Bearish Expectation: Illustration
• Suppose a speculator expects stock and SIF prices to decline over the next several days.
• In order to take advantage of falling values, the right speculative strategy would be to short the SIF
contract.
• Speculation
• Bearish Expectation: Illustration

• Suppose a speculator expects stock and SIF prices to decline over the next several days.
• In order to take advantage of falling values, the right speculative strategy would be to short the SIF
contract.
• Since the index had fallen 17 points (1200 – 1183), the investor had been correct in his expectation.
• His speculative position would earn him a total RM850. (Entry Value – Exit Value) × Multiplier = (1200 –
1183) × RM 50 =RM850.
• A speculator who had been bullish and had gone long an SIF contract on day 0 would have lost RM 850
by day 4.
• Spread Trading
• Spread trading is essentially a speculative strategy but one that has a safety net.
• Unlike an outright speculative position which is a single long or short position, spread trading
involves taking simultaneous long and short positions in the derivative asset.
• A time or calendar spread involves going long and short in two futures contracts of different
maturities.
• An intermarket spread involves going long in one market and going short the same asset in another
market.
• Bull Time Spread: Illustration

• Suppose an investor believes stock prices are likely to increase over the future.
• To profit from this expectation, the investor could establish a bull time spread in SIF contracts.
• This is done via purchasing a longer maturity contract and selling the shorter maturity or nearby
contract.
• Spread Trading
• Bull Time Spread: Illustration (Contd)
• 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
• Spread Trading
• Bull Time Spread: Illustration (Contd)
• 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
• Suppose the SIF price on 30 January was as in table,.

• The spread trade would have profited RM 300, derived as follows
• Spread Trading
• Bear Time Spread:
• 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, once again causing a widening of the spread.
• The spread trader, establishes the bear time spread as follows:
Portfolio Management & SIF Contract
• SIF contracts are also used for other portfolio management purposes.
• Adjusting Portfolio Betas with SIF Contracts
• Portfolio managers who typically hold a diverse range of stocks would largely be focused on
managing the systematic rather than total risk.
• According to modern portfolio theory, the beta of a portfolio is the weighted average of the
betas of the stocks that make up the portfolio.
• In order to achieve a desired portfolio beta, much portfolio rebalancing may be needed. Such
rebalancing would require weight re-adjustment which in turn means selling different
proportions of various stocks and adding (buying) different proportions of yet other stocks.
• A manager could easily reduce the beta of his portfolio by going short SIF contracts equivalent
to a proportion of his portfolio value.
• Adjusting Portfolio Betas - 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.
• With a beta of 1.5, your portfolio would be 50% more volatile than the stock market’s
volatility.
• Information:
Current portfolio value = RM 6,000,000
Portfolio beta = 1.50
Index level = 1,000 points
Intended portfolio beta = 1.00
• What proportion of your portfolio should you hedge?
• Adjusting Portfolio Betas - Illustration
• What proportion of your portfolio should you hedge?
• Adjusting Asset Allocation
• Asset allocation involves the allocation of funds among several asset categories; for example
among stocks, bonds, t-bills etc.
• T-bills are a key element in asset allocation.

• When markets are deemed bearish, portfolio managers would increase the weighting in t-bills (cash)
and reduce the weighting in stocks. The opposite occurs when markets are expected to be bullish.
• Adjusting asset allocation would therefore require buying/selling shares and t-bills as the case may
be.
• 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, he would short more SIF contracts and do the opposite if he wants to
reduce the t-bill position.
Issues in SIF Pricing
• Violations to Spot-Futures Parity
• Theoretically, sustained deviations from Spot-Futures parity is not possible since it would be
arbitraged away.
• However, the reality is that deviations do happen and quite often too. The reasons are as
follows:
• Transaction Costs and the No-Arbitrage Bounds

• While arbitrage is always possible whenever there are price deviations, it may not be profitable
when the mispricing is small.
• Each strategy, whether cash and carry or reverse cash and carry, has its transaction costs.
• The existence of these transaction costs creates an upper and lower bound around the fair value
(correct value) of the futures price.
• Mispricing that falls within this bound is not arbitrage able.
• Transaction Costs and the No-Arbitrage Bounds
• Mispricing that falls within this bound is not arbitrage able.
• The No Arbitrage bound is calculated via the formula:
• No Arbitrage bounds
• Inefficiencies
• In markets where information flow is not efficient, a number of reasons could lead to violations in
the parity.
• Firstly quoted prices may be stale.
• Second, in such markets there could also be more execution risk.
• Order Imbalances
• Deviations from parity may be due to order imbalances in the futures and/or spot markets.
• Regulation and Other Hindrances

• Regulatory framework may be the cause of mispricing.
• Example, government restrictions on short selling, exchange requirements on margins, tick rules,
etc.
Issues in Stock Index Futures Trading
• Volatility of Underlying Stock Market
• SIF contracts has often been blamed for having increased the volatility of the underlying stock
market.
• Critics have blamed index arbitrage activity, especially program trading for causing increased
volatility.
• Program trading was blamed for the 1987 stock market crash on the New York Stock Exchange
• Yet empirical studies have not found any evidence of an increase in underlying stock market
volatility due to SIF.
• Volume Migration from Spot to SIF

• Studies have shown that with the introduction of SIF trading, there is often a migration in
trading volume from the stock market to the SIF market.
• Evident in the Nikkei SIF markets; by about three years after the introduction of Nikkei SIF contracts
in Osaka, volume as measured by ¥en value had already matched trading value in the underlying
stock market, the Tokyo Stock Exchange.
Issues in Stock Index Futures Trading
• Lead-lag Relationships in Returns and Volatility
• Several previous studies, particularly of US markets, have documented evidence of a lead-lag
relationship between the index futures and stock markets.
• It appears that the SIF market is usually the first to react to news while the stock market then
follows.
• Patterns in Intraday Trading and Volatility

• Analysis of timed interval intraday transactions data of stocks have shown systematic patterns
in returns, trading volume and volatility.
• Typically, intraday volume and volatility have portrayed U-shaped patterns.
• Intermarket Spread Trading

• The launch of SIF contracts in various exchanges across the world, has facilitated a boom in
intermarket spread trading.
FBM KLCI Futures: Performance
Single Stock Futures (SSF)
• SSF is a futures contract on an individual listed stock.
• Being an equity futures contract, SSFs share many common features with Stock Index
Futures contracts,
• SSFs can be used for the three key applications; hedging, arbitrage and speculation.
• Like other financial derivatives, SSF contracts are cashsettled at maturity.
SSF on Bursa Malaysia
• SSF were introduced in Bursa Malaysia in April 2006
• Bursa Malaysia has ten SSF.

• Bursa Malaysia Bhd
• IOI Corporation Bhd
• AirAsia Bhd
• Maxis Bhd
• AMMB Holdings Bhd
• RHB Capital
• Berjaya Sports Toto Bhd
• Scomi Group
• Genting Bhd
• Telekom Malaysia
Contract Code SSF
Underlying Shares Selected stocks that have met the SSF selection criteria.
1) Bursa Malaysia Bhd
2) AirAsia Bhd
3) AMMB Holdings Bhd
4) Berjaya Sports Toto Bhd
5) Genting Bhd
6) IOI Corporation Bhd
7) Maxis Communications Bhd
8) RHB Capital Bhd
9) Scomi Group Bhd
10) Telekom Malaysia Bhd
Contract Size 1,000 shares
Contract Months Spot month, the next month and the next two calendar quarterly months. The
calendar quarterly months are March, June, September and December.
Trading Hours • First trading session: Malaysian Time 8:45 a.m. to 12:45 p.m.
• Second trading session: Malaysian Time 2:30 p.m. to 5:15 p.m.
Minimum Price 0.02 point valued at RM20.00
Fluctuation
Daily Price None
Limit
Speculative Maximum number of net long or net short positions to be held:
Position Limit • 1,350 contracts, or
• 2,300 contracts
(if the Average Daily Trading Volume [ADTV] of the underlying stock is more than 20
million for the most recent six-month period).
Final Trading The last Business Day of the contract month.
Day
Delivery •
Cash Settlement based on the Final Settlement Value.
•
The Final Settlement Value shall be the Weighted Average Price, rounded to 2
decimal points, or in the event the final settlement value is equidistant between
2 minimum price fluctuations, the value shall be rounded to the higher
minimum price fluctuation of the underlying share prices traded for the
morning and afternoon trading session on Bursa Malaysia on the Final Trading
Day.
Source: Bursa Malaysia Website
SSF – Trading Mechanics
• Operationally, trading SSF contracts is very similar to that of SIF contracts.
• Trading SSF Contracts – An Illustration
• Encik Ahmad is bullish about palm oil prices and intends to participate in a potential rally. He thinks
IOI Corporation Bhd. would be a big beneficiary of rising palm oil prices. It is now June 2012; he
therefore goes long 1 September 2012 SSF contract on IOI Corporation Bhd. At RM 15.00. What this
means is that he gets to ‘buy’ 1,000 IOI Corporation Bhd. stocks on the maturity day of the SSF
contract at RM 15.00 each or RM 15,000 for the one thousand stocks.
• On the day he initiates the contract, Encik Ahmad will have to place an initial margin. Depending on
his futures broker, this can vary between 10% to 25%. Variation margins also apply. Depending on
which way the underlying IOI Corporation Bhd.’s stock performs, Encik Ahmad may receive margin
calls if the stock’s price declines subsequently. On the other hand, his margin account will increase
if IOI Corporation Bhd.’s stock rises.
SSF – Trading Mechanics
• Why Use SSF?
• Being a derivative instrument requiring only initial margins, SSFs provide automotive leverage.
• They have lower transaction costs, can be used to lower risk (hedging), to short a stock
• They can be used to alter the beta of a portfolio.
• Pricing
• A SSF contract is priced based on the cost of carry model.
SSF – Applications
• Hedging
• It can be used to hedge exposure arising from that stock.
• Illustration:
• A fund manager had been accumulating a large position in RHB Capital Bhd. He had been proven
right thus far. However, with the recent resignation of its chairman and the surrounding
uncertainty, he is worried about the stock. The stock price had not reacted to the resignation but
the fund manager feels subsequent events might cause a negative reaction. He intends to lock-in
his gains on the stock thus far and remain hedged for at least the next 10 to 12 weeks, after which
he believes things should settle down. How can he hedge his position?
• Answer: Since he is long the underlying stock and would fear a fall in the stock’s price, he should
short, 3-month RHB Capital Bhd. SSF Contracts. The number of contracts to short would depend on
the size of his holding and the extent of hedging cover he wants.
• Arbitrage
• Arbitrage is the process by which one tries to profit from mispricing.
• The general rule being, to long (buy) the underpriced asset and short (sell) the overpriced
one.
• If SSF > So(1 + rf – d)t: (SSF is overpriced relative to its underlying stock.)
• Arbitrage strategy: Short SSF, long underlying (and borrow to finance the purchase of stock
by borrowing at rf rate.)
• If SSF < So(1 + rf – d)t: (SSF is underpriced relative to its underlying stock.)
• Arbitrage strategy: Long SSF, short underlying (and lend the proceeds from short sale of stock
at rf rate.)
• Arbitrage – Example
• You work at the arbitrage desk of a large mutual fund. You observe the following quotes on your
Reuters Screen.
• IOI Corporation Bhd. stock = RM 15.00
• IOI Corporation Bhd. 3-month SSF = RM 15.48
• Risk free rate: (3-month KLIBOR) = 6% (annualized)
• To check for potential arbitrage opportunity, we calculate the theoretical price of the SSF and
compare it with the quoted price. The theoretical price should be:
• Arbitrage Strategy should be to short the SSF, long the underlying stock and finance the purchase
of stock by borrowing at the rf rate.
• Arbitrage – Example
• Arbitrage Strategy should be to short the SSF, long the underlying stock and finance the
purchase of stock by borrowing at the rf rate.
• This arbitrage profit of RM 2,599 comes from mispricing and is independent of movements of
the underlying stock price.
• Speculation
• To benefit from: falling stock price, short SSF contracts.
• To benefit from rising stock price, long SSF contracts.
• Illustration
• Mr. Tan is convinced that the recent rise in oil prices is likely to have a negative impact on the
airline industry. How can Mr. Tan profit from his expectation?
• Answer: Since SSF contracts are available on AirAsia stocks, he can profit from his expectation by
going short on AirAsia SSF contracts. The size of his profit would depend on how much AirAsia
stock falls and the number of SSF contracts he shorted. Should Mr. Tan’s expectation not come
through and AirAsia stock rise instead, he would make losses on his SSF position.
• Other Applications of SSF are
• Hedge or take advantage of firm-specific events.
• SSF contracts are often used by fund managers to lock-in a target sell price on a stock
• SSF can be used to temporarily alter the beta of a portfolio. With SSF contracts, a fund
manager alters the overall portfolio beta by adjusting the beta of a single stock within the
portfolio.
• SSF can be used for executing paired-trading.

• Paired-trading is essentially taking simultaneous positions in two stocks. The positions however are
opposite to each other, that is, a long position in one and a short position in the other.
Thank You

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STOCK INDEX FUTURES CONTRACTS:

ANALYSIS AND APPLICATIONS

• You should have an understanding of the application of SIF and SSF.

2 EURO STOXX 50 Index Futures Eurex

3 RTS Index Futures Moscow

4 CSI 300 Futures China Financial Futures Exchange

5 Nikkei 225 Mini Osaka Exchange

6 E-Mini NASDAQ 100 Futures Chicago Mercantile Exchange

7 Nifty Futures National Stock Exchange- India

8 BIST 30 Index Borsa Istanbul –Turkey

9 SGX FTSE China A50 Index Futures Singapore Stock Exchange

Source: WFE/IOMA 2014 Derivatives Market Survey.

• According to Portfolio theory, investment in a broad range of stocks reduces unsystematic

• Lower Transaction Cost

• According to Portfolio theory, investment in a broad range of stocks reduces unsystematic

• Market Exposure and Stock Selection

• Hedging, Portfolio Insurance and Risk Management

• Managing Systematic Risk:

• Hedging the Overall Value of a Portfolio:

• Value weighted (capitalization weighted) index

• Geometrically weighted index

• Each method of computation has its own advantages and disadvantages.

• In a price weighted index, every stock has equal weight.

• Example: S&P 500, TOPIX, FBM KLCI

• On day 2, the index would be reported to have gone up 2.29 points.

• It is a difficult method to replicate for index calculations.

• Example : Valueline index

• Contract Months, tells us the fixed maturity periods of the contracts.

• Example: Assume the FBM KLCI is now at 1,000 points

• What would be the correct price of a SIF contract if it matures in

• Ringgit value = 979.01 points × RM 50 = RM 48,950.50

• Ringgit value = 998.40 × RM 50 = RM 49,920.00

• Arbitrage is possible whenever the Futures-Spot parity is violated.

• Suppose following information is given

• Since there is mispricing, arbitrage is possible.

• Assume the following two possible scenarios

• Whether the index went up or down, Profit of RM 211.80 of profit.

• This proves that the arbitrage profit is independent of market performance.

• The arbitrage profit which is 0.35% (RM211.80/RM60,000) approximates the percentage

• The size of the arbitrage profit is determined by extent of the mispricing.

• The SIF is underpriced relative to spot.

• The SIF is underpriced relative to spot.

• According to base hedge he can short 20 SIF contracts.

• Established on this. The fund manager goes short 24 contracts in SIF.

• Long futures ⇒ we pay premium of 4%; (0.06 – 0.02) (rf – d)

• Long stock portfolio ⇒ we receive the dividend yield; +0.02 or 2%

• Bearish Expectation: Illustration

• Bull Time Spread: Illustration

• Suppose the SIF price on 30 January was as in table,.

• The spread trader, establishes the bear time spread as follows:

• What proportion of your portfolio should you hedge?

• T-bills are a key element in asset allocation.

• Transaction Costs and the No-Arbitrage Bounds

• The No Arbitrage bound is calculated via the formula:

• Regulation and Other Hindrances

• Volume Migration from Spot to SIF

• Patterns in Intraday Trading and Volatility

• Intermarket Spread Trading

• Like other financial derivatives, SSF contracts are cashsettled at maturity.

• Bursa Malaysia has ten SSF.

• To benefit from rising stock price, long SSF contracts.

• SSF can be used for executing paired-trading.

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