Pricing Equity Index Futures Homework Help

Pricing Equity Index Futures

A futures contract on the stock market gives its owner the right and obligation to buy or sell the portfolio of stocks characterized by the index. Stock index futures are cash settled there is no delivery of the underlying stocks. The main differences between commodity and equity index futures are that: (i) There are no costs of storage involved in holding equity and (ii) Equity comes with a dividend stream, which is a negative cost if you are long the stock and a positive cost if you are short the stock. Therefore, cost of carry = financing cost dividends. Thus, a crucial aspect of dealing with equity futures, as opposed to commodity futures, is an accurate forecasting of dividends. The better the forecast of dividend offered by a security, the better is the estimate of the future price. The pricing of equity index futures is illustrated below with reference to (i) expected dividend amount and (ii) expected dividend yield.

Pricing Index Futures Given Expected Dividend Amount

The pricing of index futures is also based on the cost of carry model, where the carrying cost is the cost of financing the purchase of the portfolio underlying the index, minus the present value of dividends obtained from the stocks in the index portfolio.

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