Financial Markets and Institutions (2-downloads)

Index

S&P 500 Index (CME) $250 

⫻ Index

Open

High

Low

Settle

Change

Open Interest

June

1117.9

1122.8

1099.00

1109.90

–8.8

295,895

Dec

1109.3

1118.0

1096.00

1105.60

–8.90

16,822

Source: Wall Street Journal May 19, 2010, p. C9.

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Chapter 24 Hedging with Financial Derivatives

605

a profit of $25,000 because you agreed to receive a $250,000 purchase price for the

contract but have a delivery amount due of only $225,000. Because the amount

payable and due are netted out, only $25,000 will change hands; you, the seller of the

contract, receive $25,000 from the buyer.

T H E   P R A C T I C I N G   M A N A G E R

Hedging with Stock Index Futures

Financial institution managers can use stock index futures contracts to reduce stock

market risk.

Suppose that in March 2010, Mort, the portfolio manager of the Rock Solid Insurance

Company, has a portfolio of stocks valued at $100 million that moves percentagewise one-

for-one with the S&P Index. Suppose also that the March 2011 S&P 500 Index contracts

are currently selling at a price of 1,000. How many of these contracts should Mort sell

so that he hedges the stock market risk of this portfolio over the next year?

Solution

Because Mort is holding a long position, using the basic principle of hedging, he must

offset it by taking a short position in which he sells S&P futures. To calculate the number

of contracts he needs to sell, he uses Equation 1.

VA = $100 million

VC = $250 

⫻ 1,000 = $250,000

Thus,

NC = $100 million/$250,000 = 400

Mort’s hedge therefore involves selling 400 S&P March 2011 futures contracts.

E X A M P L E   2 4 . 3 Hedging with Stock Index Futures

If the S&P Index falls 10% to 900, the $100 million portfolio will suffer a

$10 million loss. At the same time, however, Mort makes a profit of 100 

⫻ $250

= $25,000 per contract because he agreed to be paid $250,000 for each contract

at a price of 1,000, but at a price of 900 on the expiration date he has a delivery amount

of only $225,000 (900 

⫻ $250). Multiplied by 400 contracts, the $25,000 profit per

contract yields a total profit of $10 million. The $10 million profit on the futures con-

tract exactly offsets the loss on Rock Solid’s stock portfolio, so Mort has been suc-

cessful in hedging the stock market risk.

Why would Mort be willing to forego profits when the stock market rises? One

reason is that he might be worried that a bear market was imminent, so he wants

to protect Rock Solid’s portfolio from the coming decline (and so protect his job).

1

1

For more details of how stock market risk can be hedged with futures options, see the appendix to this

chapter which can be found on the book’s Web site at