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Five Things Every Investor Should Know About Index Futures

Commonly traded classes of futures are grains (wheat, soybean, corn); metals (gold, silver); livestock (pork bellies, live cattle); financials (equity index, government bonds, Eurodollars); and exotics (weather, pollution emissions).

Equity index futures are a type of financial future that tracks popular broad-based indices, such as the S&P 500 (SPX), the Russell 2000 (RTY) and the Nikkei 225 (NKX).

Also, equity index futures contracts are cash settled, which means that upon expiration -- rather than upon delivery of assets as with the S&P 500 stocks -- a final cash gain and loss is passed between the contacting parties.

2. Futures Pricing: Cheaper Now or Later?

As the name implies, futures represent some forward valuation of an asset. This raises the question, "Is it cheaper to buy the asset today or in the future?" Thus, we have to begin the process by determining a break-even or fair value price for a future relative to the current spot price (or cash price). In order to do so, you have to consider two important variables: interest and dividends .

Interest: Let's say that the spot price for the SPX is currently $1,600 and you are contemplating the purchase of a futures contract with a maturity date of exactly three months from now. Currently, you can borrow money at your corner brokerage or bank at a rate of 6% for a three-month maturity. So if you borrowed $1,600 today, then in three months' time (a quarter of a year), you would have to return $1,624 to the lender ($1,600 plus 6% of $1,600 times 25%). Thus, in a world devoid of dividends, with so little interest accrued, you would probably be indifferent to whether you paid $1,600 for the SPX today in the current market or $1,624 for the SPX in the future.

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