Stock Index Futures

The stock index is an indicator used to measure and report value changes in a selected group of stocks. It is important that a stock index can track the market movements depending on its composition and the weighing of individual stocks.

Besides, the futures contract is a type of derivative instrument, in which two parties agree to transact a set of financial instruments or physical commodities for future delivery at a particular price. In every futures contract, everything is specified: the quantity and quality of the commodity, the specific price per unit, and the date and method of delivery. And the “price” of a futures contract is represented by the agreeable price of the underlying commodity or financial instrument that will be delivered in the future. Therefore, a stock index futures contract has combined the function of two above and made the market more diversified.

Trading in futures originated in Japan during the 18th century and was primarily used for the trading of rice and silk. It wasn't until the 1850s that the U.S. started using futures markets to buy and sell commodities such as cotton, corn and wheat. The first index future was born in the Kansas City Board of Trade (KCBT). This contract takes the lead with a future on the Value Line Index, which started trading in February 1982. It took the KCBT five years to get the contract approved. As happens so often in the real world, the first was not always necessarily the most successful. It was the next index launched to become the leader: the S&P 500. The S&P 500 index was introduced in the Chicago Mercantile Exchange (CME) on 21 April 1982. After that, there were more and more other different index futures produced successively.

From the viewpoints of Taiwan, the Chicago Mercantile Exchange and Singapore International Monetary Exchange (SIMEX) introduced the first future

This was an important milestone for Taiwan’s future market. Some new financial instruments, including warrant contracts on approved stocks, exchange rate futures and foreign exchange options, were also listed on the Taiwan Stock Exchange or allowed trading over-the-counter in 1997. Following the passage of the Taiwan Futures Trading Law, the local futures exchange was opened in October 1997 and the Taiwan stock index futures (TX) was inaugurated in July 1998. Trading on indexes of electronic sector (TE) and financial sector (TF) futures was open in 1998 to make firms and individuals more flexible in hedging their risks against the volatility of commodity prices, exchange rates, interest rates and stock prices. Subsequently, the mini Taiwan stock index futures (MTX) was launched on April 2001 and provided a smaller contract for investor to transaction.

Until now, stock index futures contracts still play an important role in the financial markets. The reason why it can succeed is that index future can reflect fairly the demand and supply of the changeable economic society. There are some vital economic functions of the stock index futures as following.

Price Discovery -- Due to its highly competitive nature, the index futures contracts has become an important economic tool to determine prices, based on the estimated demands of today and tomorrow. Futures market prices depend on a continuous flow of information from around the world and thus require a high amount of transparency. Some continuous and open outcry auction is an excellent method for accurately determining the price level, while the information constantly changes the price of a commodity. This process is known as price discovery.

Risk Reduction -- Futures markets are also a place for people to reduce risk when making purchases. Risks are reduced because the price is pre-set, therefore letting participants know how much they will need to buy or sell. This helps reduce the ultimate cost to the retail buyer, because with less risk there is less chance of manufacturers jacking up prices to make up for losses in the cash

market.

Speculation -- Speculation involves the buying, holding, and selling of stocks, commodities, futures, currencies, real estate, or any valuable thing to profit from price fluctuations as contrary to buying it. The players in the futures market fall into two categories: hedgers and speculators. A hedger buys or sells in the futures market to secure the future price of a commodity intended to be sold at a later date in the cash market. This helps protect against price risks.

However, a speculator aim to benefit from the every price change, while a hedger focus on protecting themselves against. Speculators want to increase their risk and therefore maximize their profits and hedgers want to minimize their risk no matter what they're investing in. Table 1 illustrates the major distinction between hedger and speculator.

Table 1.1 Hedger and Speculator

Long Short

Hedger Secure a price now to protect against future rising prices

Secure a price now to protect against future declining prices

Speculator Secure a price now in anticipation of rising prices

Secure a price now in

anticipation of declining prices

Arbitrage -- The investor can simultaneous purchase and selling of an asset to profit in different price. This usually takes place on different exchanges or marketplaces. Also known as a "riskless profit". In the process of risk arbitrage, traders can find opportunity to profit and make the price of spot and future close to each other. Therefore, the existences of future markets contribute to improving the efficiency of the financial markets.

Diversification Investment -- Owing to the underlying object of stock index future is stock index, the calculation has regulator formulation and not

easy to be manipulated. Besides, investors spend less money buying the whole stock market commodities indeed make the investment channel greatly diversified.

The unique aspects of futures markets, as compared with other marketplaces, have been the focus of discussion. For the most part, hedging techniques involve using complicated financial instruments known as derivatives, the two most common of which are options and futures. This dissertation takes hedging function of futures as a starting point. From the viewpoints of investors with spot market position usually take an opposite contract position in the futures market, being used as a hedge strategy to reduce risks.