Chapter 10, Stock Index Futures. Now, through the program, we've looked at some examples of stock index futures already, but let's look at them more specifically. Now, first of all, with stock index futures, they will give you a multiplier on the test. You can think of the multiplier like the contract size. So if they tell you the multiplier is $250, then what that means is each index point equals $250. So the way you can convert the index value into a value of the entire contract is by multiplying by this given multiplier. Or if you figure out a profit or loss that you made 6 and a half points, well, what does that convert to in dollars? you would multiply it by the given multiplier and the test will give you the multiplier to use although we'll look at some of them in a second. Now, stock index futures can often be used to hedge a position. Now, there's two types of risk. There's nonsatic risk and systematic risk. Nonsistatic risk is individual stock risk. So it's really a combination of the specific company risk and maybe a bit of the industry risk. Nonsatic risk that individual stock risk can very easily be reduced through diversification. So if you put all your eggs in one basket and only own one stock, you have a lot of risk in that specific company risk. But if you diversified and bought many many different stocks, you will have reduced non-sistatic risk through that diversification. Now there's also systematic risk. You can think of this as more overall market risk. If the entire market if the market falls by 20%. Even if you're well diversified, you're going to lose roughly 20% most likely on your portfolio. So this risk really cannot be eliminated through diversification. Stock index futures address this systematic risk, this overall market risk. So if we were long a portfolio of 117 different stocks, we've effectively reduced our nonsistatic risk because we own all these different stocks. But if the market fell 20%, we would expect our portfolio to still fall by roughly that 20%. So that's what we can hedge through the use of stock index futures. Now, we mentioned that the contract size for the index futures is a multiplier. Here you could see some multipliers. The S&P 500 $250 per point. But then on the test, they are asking a mini contract where they'll give you perhaps that each point is worth $50. And here we see some other examples of multipliers, but again from what we hear they will tell you the multiplier on the test. Now look at the bottom of the slide and you could see that index futures contracts are cash settled. So you actually do not deliver or receive a basket of 500 stocks as weighted in the S&P 500. That would not be a very logistically convenient way to have the contract settled. Remember, if you have a corn contract, there's actually delivery of 5,000 bushels of corn if you hold that open till delivery. But index futures do not work that way because it's really not feasible to deliver this basket of 500 stocks as weighted in the S&P 500, for example. So the way they settle them is they cash settle index futures. Now let's take a look at a stock index futures application question. A customer places an order to buy three S&P 500 futures contracts. The multiplier is $250 per index point. The initial margin requirement is $66,000 per contract and the maintenance is 60,000 per contract. The customer deposits the required margin in his account. The customer's order is filled and a long position of three contracts is established at 2,833.30 points. Now that night, the settlement price for the December futures contract is 28.25.80. Calculate the current equity in the customer's account. Now again, even though we're not calling this an application question, it clearly is. So feel free to pause the video and try to calculate this on your own first. Okay, let's take a look at how we would calculate this. So what's the question asking first of all? Well, the client put up a certain amount of margin to establish the position. We then mark the position to the market. What does that mean? They're telling us that the futures have moved. So, this client has either made money or lost money. If we've made money, our equity has gone up. If we've lost money, our equity has gone down. We're comparing the original value to this new settlement value. And that's what marking to the market is. And our equity has moved up or down based on that unrealized gain or loss that we have to date. So, let's take a look at the calculation. When we established the position, we went long, they told us, at 2833.30. The settlement value now is 28.25.80. So, we have a loss of 7 12 points. Now, how much does each point represent? That's where we use the multiplier. 7 12 points times the multiplier of $250 per point means we've lost $1,875 per contract. So we have a loss which we're calling here that open trade equity if you remember the margin lecture but you could just think of it as a loss to date of $1875 per contract. So what's our equity per contract? Well, we put up 66,000. So far, we've lost $1875. So, our equity per contract is $64,125. Now, be very careful. That might be a choice on the test, and it would be wrong. Why? Cuz they clearly tell us we did three contracts. So, our total equity is 64,125 per contract times three contracts, which gives us our correct answer of $192,375. Now, as an alternative, the way some people calculate this is they say you deposited $66,000 per contract. They multiply that by three. So, that was your total margin deposit. Then they figure out the total loss of $1875* 3 and subtract that off of that total margin which would be just as correct. So whichever way you're more comfortable doing it. Let's take a look at another activity. So again feel free to pause the video and give it a try before we look at it together. Okay, let's take a look at the question. A customer has a large blue chip stock portfolio. She anticipates a market decline and wants to hedge $5 million of the portfolio using the S&P 500 futures. Each index point, they tell us equals $250. The futures price is currently $29.95.20. Which of the following is the best hedging strategy? to buy 20 contracts, to sell 20 contracts, to buy six contracts, or to sell six contracts. Well, the first thing we have to determine is would we buy futures or sell futures. The customer is long the portfolio. A customer has a large blue chip stock portfolio. They're not telling us they're short. So, the assumption would be they're long this portfolio. So they want the portfolio to go up. What they're concerned about, what their fear is is that it's going to fall. So we want to do something to profit in case it falls. So we're going to sell futures to hedge. That's the first thing we have to determine. So our answer is either do we sell 20 futures B or do we sell six futures contracts which is D. Now we have to do the math. Well, how much does each contract represent? Each contract is $29.95.20. The multiplier is $250 per point, which if you do the multiplication, the value of the futures contract is $748,800. So that's how much stock is represented by each futures contract because the multiplier is $250 and they give us the value of that futures contract. Now, how much stock do we want to hedge? $5 million worth. So clearly one contract doesn't do it. So how do we figure out how many contracts to use? We divide what we want to hedge. In this case $5 million by what each contract represents, which is $748,800. And when we do the division, we get we need 6.6774 contracts. Now remember, if they're saying how many contracts do you use to hedge, the way they want you to do it is to round down to avoid being a speculator on a fraction of that last contract. So notice our best choice here is we would sell six S&P 500 contracts. What's next? We'll look at commodity options. But again before moving on you may want to go to create custom exam and create a mini test on this chapter since this is a short chapter. Okay, I would create a very small mini test on this chapter. Then move on to the next chapter and we will look at commodity options.