Financial derivatives — such as futures or options — are a powerful technique through which hedging, speculation, investment and arbitrage takes place in a modern economy.
The major products of the equity derivatives industry worldwide, is Index derivatives.
Internationally, trading volume on index derivatives is multi times larger than that of securities derivatives.
Index Derivatives are mainly traded by professional traders, investors and portfolio managers to protect equity portfolio, to arrange cost-effective exposure to an index.
while purchasing the underlying shares, to take a trading view on the direction of the market.
Benefits of Trading Equity Index Derivatives
Price transparency and liquidity
Lower transaction fees than those incurred when buying or selling the basket of securities making up the index
Immediate execution and confirmation
Reduction of counter-party risk
Standardized contracts available
Cash settled contracts available
Index Futures
Index futures are futures contracts whereby investors can buy or sell a financial index today to be settled at a date in the future.
Portfolio managers use index futures to hedge their equity positions against a loss in stocks.
Speculators can also use index futures to bet on the market’s direction.
Some of the most popular index futures are based on equities including the E-Mini S&P 500, E-Mini NASDAQ 100, and E-Mini Dow.
International markets also have index futures listed.
Index Futures for Hedging
If the manager has positions in a large number of stocks, index futures can help hedge the risk of declining stock prices by selling equity index futures.
Since many stocks tend to move in the same general direction, the portfolio manager could sell or short an index futures contract in case stocks prices decline.
In the event of a market downturn, the stocks within the portfolio would fall in value, but the sold index futures contracts would gain in value offsetting the losses from the stocks.
The fund manager could hedge all of the downside risks of the portfolio, or only partially offset it.
