Financial Markets and Institutions (2-downloads)

Contracts

Given the $1 per euro price, the sale of the contract yields 80 

⫻ 125,000 euros

= $10 million. The futures hedge thus again enables her to lock in the exchange

rate for Frivolous Luxuries so that it gets its payment of $10 million.

One advantage of using the futures market is that the contract size of 125,000

euros, worth $125,000, is quite a bit smaller than the minimum size of a forward

contract, which is usually $1 million or more. However, in this case, the bank man-

ager is making a large enough transaction that she can use either the forward or

the futures market. Her choice depends on whether the transaction costs are lower

in one market than in the other. If the First National Bank is active in the forward

market, that market would probably have the lower transaction costs, but if First

National rarely deals in foreign exchange forward contracts, the bank manager may

do better by sticking with the futures market.

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Chapter 24 Hedging with Financial Derivatives

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Stock Index Futures

As we have seen, financial futures markets can be useful in hedging interest-rate risk.

However, financial institution managers, particularly those who manage mutual funds,

pension funds, and insurance companies, also worry about stock market risk, the

risk that occurs because stock prices fluctuate. Stock index futures were developed

in 1982 to meet the need to manage stock market risk, and they have become among

the most widely traded of all futures contracts. The futures trading in stock price

indexes is now controversial (see the Mini-Case box below) because critics assert

that it has led to substantial increases in market volatility, especially in such episodes

as the 1987 stock market crash.

Stock Index Futures Contracts

To understand stock index futures contracts, let’s look at the Standard & Poor’s

500 Index futures contract (shown in the Following the Financial News box, “Stock

Index Futures”), the most widely traded stock index futures contract in the United

States. (The S&P 500 Index measures the value of 500 of the most widely traded

stocks.) Stock index futures contracts differ from most other financial futures con-

tracts in that they are settled with a cash delivery rather than with the delivery of

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