In public, and particularly in the news media, the word “derivatives” always seems to be spoken with ire or disgust. Stories involving derivatives are usually aimed at shaming greedy “Wall Street types” or describing the calamitous damage inflicted by an ill-conceived derivatives position. Wherever derivatives are mentioned there is likely a picture or graphic containing either handcuffs or a face-palming trader. Even Warren Buffett called derivatives “financial weapons of mass destruction.” But is there really cause to be terrified of derivatives as a whole? Part of the problem is that “derivatives” is a very large asset class, describing all assets whose values are derived from a notional amount and an observable event (e.g., default of a particular company) or underlying value (e.g., an interest rate or stock price). Thus “derivatives” have the potential to be very complicated. But because it is such a large asset class, maybe some derivatives are very simple. Maybe some derivatives are liquid and accurately priced. Maybe some derivatives are regulated. Maybe some derivatives allow for very cost-effective risk management. Exchange-traded equity index futures are that type of derivative. They are boring derivatives.
When investors execute equity index futures contracts they are agreeing to either buy (long) or sell (short) the value of the underlying index at contract expiration for the price as stipulated in the contract. For instance, if an investor were to take the long position in an S&P 500 futures contract, when the S&P 500 futures price was 1400, at contract expiration they would be required to pay:
(1400 – S&P 500 value at contract expiration) * contract multiple, where “contract multiple” is a standard contract term essentially defining the notional of the contract
Should the S&P 500 be higher (or lower) than 1400 at contract expiration, this value would be negative (or positive), indicating a negative (or positive) payment be made by the investor. Another way of saying this is that the investor would realize a gain (or loss). The reason for this is that the investor previously agreed to pay 1400 for something that is now worth more (or less) than 1400.
The potential gain or loss from a contract of this sort could grow quite large. It is because of this potentially large loss that margin is required to engage in futures trading. The amount of margin required is set by the futures exchange. As markets fluctuate and unrealized losses (or gains) become large, additional margin deposits may be required (or excess margin may be withdrawn). Open contracts can be, and in practice usually are, settled prior to expiration by entering into exactly offsetting positions, thereby realizing any previously unrealized gain or loss.
From a risk management point of view, the potential benefit of utilizing equity index futures contracts comes from the fact that large exposures can be acquired for minimal cash outlays. Margin requirements are roughly reflective of the exchange’s view of volatility and the investor’s open positions. In this way, an investor’s required margin is the amount roughly equal to that necessary to cover a large, unlikely, one-day loss on open contracts. For instance, in order to get an exposure the equivalent of $100,000 to the S&P 500, the required margin might be $10,000. By engaging in net short positions in equity index futures, investors can greatly reduce their broad market equity exposures without having to liquidate their equity holdings.
Equity index futures contracts are exchange-traded, meaning an exchange facilitates all trading. Margin is required of net long traders and net short traders. As markets move, gains accrue on one side, washing out losses on the other. The margin requirements protect the exchange and virtually guarantee each investor’s ability to settle their potential liability. As such, it’s very likely that equity index futures will remain boring derivatives. That’s exciting.