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Advantages of Stock Index Futures

Advantages of Stock Index Futures

Advantages of Stock Index Futures: Investors can use stock index futures to perform myriad tasks. Some common uses are:

(1) Investors commonly use stock index futures to change the weightings or risk exposures of their investment portfolios. A good example of this is investors who hold equities from two or more countries. Suppose these investors have portfolios invested in 60 percent U.S. equities and 40 percent Japanese equities and want to increase their systematic risk to the U.S. market and reduce these risks to the Japanese market.

They can do this bybuying U.S. stock index futures contracts in the indexes underlying their holdings and selling Japanese contracts (in the Nikkei Index).

Advantages of Stock Index Futures

(2) Stock index futures also allow investors to separate market timing from market selection decisions. For instance, investors may want to take advantage of perceived immediate increases in an equity market but are not certain which securities to buy; they can do this by purchasing stock index futures. If the futures contracts are bought and the present value of the money used to buy them is invested in risk-free securities, investors will have a risk exposure equal to that of the market. Similarly, investors can adjust their portfolio holdings at a more leisurely pace. For example, assume the investors see that they have several undesirable stocks but do not know what holdings to buy to replace them. They can sell the unwanted stocks and, at the same time, buy stock index futures to keep their exposure to the market. They can later sell the futures contracts when they have decided which specific stocks they want to purchase.

(3) Investors can also make money from stock index futures through index arbitrage, also referred to as program trading. Basically, arbitrage is the purchase of a security or commodity in one market and the simultaneous sale of an equal product in another market to profit from pricing differences. Investors taking part in stock index arbitrage seek to gain profits whenever a futures contract is trading out of line with the fair price of the securities underlying it.

(4) Investors often use stock index futures to hedge the value of their portfolios. Provide hedging or insurance protection for a stock portfolio in a falling market. To implement a hedge, the instruments in the cash and futures markets should have similar price movements. Also, the amount of money invested in the cash and futures markets should be the same.

Advantages of Stock Index Futures

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