New futures contract proving popular

Press, 26 February 1987, Page 31

New futures contract proving popular

By Lincoln Gould — New Zealand. Futures Exchange, Ltd. The new Barclays Share Price Index futures contract appearspopular with large numbers of individual investors in sharp contrast to more esoteric contracts traded by the New Zealand Futures Exchange.

The contract was launched on January 5 this year and vollimes have been building from the first day. It is probably fair to note that large institutions have not yet’ integrated the new contract with their risk management systems and when they do, volumes will rise even more sharply. Undoubtedly, a big factor is that larger numbers of individuals are involved in and understand the underlying physical market Thus they see the relevance of the futures contract to their own position in the share market. The intricacies of interest rates and exchange rates tend to keep all but the committed futures trader away from other types of futures contract — even wool is a specialist area. But in New Zealand there are many "experts” in the share market and with the “bear” nature of the market since Christmas the introduction of the new futures market is seen as a safety net against falling prices. Whether a hedger or a speculator, trading in a futures market is different from investing in stocks and shares. Great care needs to be taken to understand how futures trading is carried out in New Zealand — what opportunities there are and

the pitfalls. Share Index Futures are a comparatively recent innovation, having first commenced trading in the United States in 1982.

In their simplest application, share price index futures are a substitute for holding shares, although not an exact substitute.

They fulfil two major economic functions:

Firstly, they provide a mechanism by which those exposed to sharemarket risk can hedge, or obtain protection from those risks. Secondly, they foster price discovery, that is, they provide a concensus of opinion and expectation about sharemarket movements, formulated into a price for a particular future time.

The risk transfer function of the market is by far the most important. Portfolio managers, large shareholders and others find it difficult, if not impossible, to change their sharemarket exposure quickly without affecting the sharemarket itself.

Share price index futures provide a means of achieving a change in portfolio exposure quickly, effectively and at a low cost without buying or selling a single share.

Before entering into a futures contract, each trader in the market (whether a hedger or speculator) is required to put up a deposit usually amounting to a small percentage of the value of the underlying commodity. Currently the deposit for the Barclays Share Index Futures contract is $l6OO.

This deposit is by nature, a performance bond and is required to protect the interest both of the broker and of other

participants in the market

If at any stage a trader is unable to meet a margin call to cover a market move against him/her, the position may be closed out and the resulting loss deducted from the deposit before the balance is returned. If margin calls are met or if profits are realised on a futures transaction, the deposit is returned with interest at the time the contract is closed out

From the speculator's point of view, a feature of futures trading creates what is known as financial leverage; that is, the possibility of making large profits or losses on a small outlay of capital. It creates the possibility of high percentage returns on funds for those who are successful, but multiplies the level of risk on funds outlaid for those who are not.

The other major difference between the futures market and the sharemarket is that it is possible to sell short (that is, agree to sell a commodity not owned by the trader) on the futures market, whereas this is in most cases impossible in the sharemarket. A trader who takes a contract to sell does so in anticipation of a price fall in that commodity. If the price fall should eventuate, he/she would then be able to profit by taking a new contract to buy at the lower price, which would close out his/her position and remove the contractual obligation to deliver the commodity. Speculators, will use stock index futures to buy a position in the market in anticipation of a rise and to sell a position in the market in anticipation of a decline.

If a speculator trades in stock index futures he/she

needs to recognise that these contracts have a finite’ life and that they involve the holding in an obligation to close out his position or settle at the maturity of the contract Stock .price index futures enable portfolio holders to protect themselves against market risk. The total risk of stocks may be separated into two components, usually to as unsystematic and sytematic or market risk. Unsystematic factors are stock-specific factors such as earnings reports on threats of industrial action. This component, of stock price may be rfeduced or eliminated by holding a diversified portfolio. An unsystematic risk is diversified away in this manner, the second component becomes more important. This second component is systematic or market risk which captures the response of individual stock prices to general market swings caused by events which affect the market as a whole.

Price changes induced by market swings are common to all stocks and cannot be eliminated through diversification. Market risk is a significant part of the total risk for any individual stock and it becomes even more important in large portfolios as unsystematic risk is diversified away. A portfolio holder who wanted to protect the value of the portfolio by selling short stock index futures can identify the number of contracts necessary to hedge the portfolio by dividing the value of the portfolio by the value of the futures contract and multiplying the portfolio Beta. Large swings in market values may be neutralized by using stock index futures to vary the risk and return characteristics of a stock portfolio without changing its composition. For a portfolio that contained the precise index mix of stocks, selling a stock index futures contract has the effect of locking in a future portfolio value and transfer-

ring the entire risk of market fluctuations to the buyer of the futures contract.

It is unlikely that portfolios will exactly match an index which means that a cross-hedge is the normal process for hedging using stock index futures. That is the decision to hedge a particular portfolio will involve a certain degree of risk referred to as the basis risk on the difference between the index and the index futures price. We h could expect that the basis risk will be caused by non-systematic risk, by dividends which will be included in portfolios. The /size of the basis risk is limited by the possibility of arbitrage between cash and futures markets. ,• All of these aspects need to be carefully considered before trading with a detailed strategy being developed particularly in consultation with your broker. ;