Index Futures

Index futures are futures contracts whose underlying is a stock market index instead of a physical commodity or a single security. The buyer and seller agree today on a level of the index for a future date, and the contract is settled in cash for the difference, since an index itself cannot be delivered. They are among the most heavily traded derivatives in the world.

The contracts let investors take or remove exposure to a whole market in one trade. Fund managers use them for hedging and for managing cash flows, traders use them to speculate, and arbitrageurs keep their prices in line with the underlying shares. In the United States they trade mainly on the Chicago Mercantile Exchange and are regulated by the Commodity Futures Trading Commission. Comparable contracts are listed on exchanges in Europe, India, Japan and elsewhere.

Each contract has a multiplier that converts index points into money. The contract's notional amount is the futures price times the multiplier:

The E-mini S&P 500 future has a multiplier of $50. With the future at 5,000, one contract controls $5{,}000 \times 50 = 250{,}000$ dollars of exposure, and a move of 10 index points changes its value by $500. The Micro E-mini contract has a multiplier of $5, one-tenth the size. Contracts are listed for quarterly expiry months, and most trading is in the nearest one. A position is carried forward by closing the expiring contract and opening the next, which is known as rolling.

A trader does not pay the notional value. Both sides deposit initial margin, a fraction of the contract value set by the exchange's clearing house, which stands between buyer and seller. Each day positions are revalued through mark-to-market: losses are debited and gains credited in cash as variation margin. The arithmetic is set out in the entry on futures profit and loss.

Because margin is a small part of notional value, index futures carry high leverage. If margin on the contract above were $12,500, or 5 percent of notional, a 2 percent fall in the index would cost a buyer $5,000, which is 40 percent of the deposit. This is the main source of risk for speculative users.

The fair price of an index future is the index level plus the cost of financing the shares to expiry, less the dividends they would pay. When interest rates exceed the dividend yield, the future trades above the index, and when dividends are higher it trades below. Deviations from fair value are traded away through index arbitrage. At expiry the futures price converges to a final settlement value calculated from the prices of the index's constituent shares.

The difference between the futures price and the index level is the basis. It narrows as expiry approaches, and it can move away from its fair level for short periods when markets are under stress or when one of the two markets is closed. A hedger is therefore exposed to changes in the basis even when the hedge ratio is right.

• Hedging. A portfolio manager who expects a short-term fall can sell futures instead of selling shares. The number of contracts is the portfolio's value times its beta, divided by the notional value of one contract. A $10 million portfolio with a beta of 1.1, hedged with a contract worth $250,000, needs $1.1 \times 10{,}000{,}000 / 250{,}000 = 44$ contracts.
• Equitising cash. A fund that receives new money buys futures to gain market exposure at once, then replaces them with shares over time.
• Asset allocation. Shifting between markets with futures is cheaper and faster than trading the underlying shares.
• Trading. Futures trade nearly around the clock, can be sold short as easily as bought, and are a main instrument for trend following and other systematic strategies.

Index futures prices are also watched as an indicator. Because they trade when stock exchanges are closed, they show how the cash market is likely to open.

The first stock index future, on the Value Line index, was listed by the Kansas City Board of Trade in February 1982. The Chicago Mercantile Exchange followed with its S&P 500 contract in April of that year. The electronically traded E-mini version was launched in 1997 and became the main contract, and the Micro E-mini was added in 2019. Contracts on other major indices followed around the world, including the FTSE 100, the DAX, the Nikkei 225 and India's Nifty 50.

• CME Group
• Commodity Futures Trading Commission