A CAPM-based analysis of stock index futures

Abstract

T he recent introduction of trading in stock index futures represents the implementation of a most innovative idea with far-reaching financial implications. These futures are likely to open new investment horizons in derivative assets and will improve both the liquidity and the efficiency of the secondary markets. Furthermore, as has been suggested in a recent article by Grant [6] in this Journal, trading in stock index futures is expected to simplify the process of optimal portfolio selection for investors and to alter the composition of portfolios held in the absence of a futures contract in some index. In this article, we propose to explore some of the important implications of stock index futures trading for equity investors and especially for professional portfolio managers. The aforementioned paper by Grant [6] motivates our effort, while subsequent articles by the same author [7] and others [5] provide a convenient and sound foundation for deparhres and interesting analytical extensions. Whereas Grant [7] employs an arbitrage argument, we utilize the more familiar and well-tested Capital Asset Pricing Model (CAPM) framework. Moreover, while Grant posits hedging as the motivational scheme for trading in stock index futures, we allow for the existence of risk in the marketplace assuming the presence of rational risk-averse investors who participate on both sides of the market by buying and writing stock index futures at the right price. We first derive a CAPM-based formula that provides (1) the systematic risk of a stock index fu-