The Finance Professor

Try Jim Cramer's Action Alerts PLUS
CLICK HERE NOW

Five Things Every Investor Should Know About Index Futures

07/24/07 - 04:32 PM EDT

Scott Rothbort

Dividends: The current dividend yield yield on the SPX is around 2%. For this basic example, here are a few simple assumptions:

  • Dividends are distributed on a continuing amortized amortization basis. That is to say that the 2% dividend will be earned evenly each and every day over the next 365 days.
  • Dividend rates are fixed, and companies will not increase or cut dividends at any time.
With this in mind, you can expect to earn $8 (2% of $1,600 times 25%) in dividends at the end of the three-month period that would coincide with the futures contract you are considering. So if you bought the SPX today, you would earn $8 in dividends over the next three months. On the other hand, if you bought the futures contract, you would forgo any dividends on the index.

In these simple terms, you can now calculate the fair value of the SPX index futures contract. If you bought the SPX today, you would pay $1,600 for the purchase, incur $24 in interest charges and earn $8 of dividends. Your net cost would be $1,616 ($1,600 plus $24 minus $8). Again, it probably wouldn't make much difference to you whether you bought the SPX at $1,600 today or bought a futures contract to buy the index at $1,616 in three months.

Of course, things are not that simple in the real world. Consider these points:

  • Interest rates vary from individual to individual and institution to institution.
  • Dividends are not constant. Companies will pay dividends on any day they choose. Some companies pay quarterly, while others pay on an annual basis.
  • Dividends are not certain. Companies can raise, lower or omit dividends.

The above shifts are factored in by market participants to arrive at a fair value for the index futures. Understanding this, you can now determine whether the futures are priced for a market move, and if so, the direction of the move, as well as the extent to which the futures are mispriced relative to the underlying cash index.

At the time of publication, Rothbort was long SPY (the ETF corresponding to SPX), although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.


Investing A-to-Z

The Finance Professor

Go To Section Home


07/11/07
Five Missteps to Avoid in Earnings Season

Here's how not to make the biggest blunders.


06/21/07
Finance Professor: Five Hedging Techniques You Must Know

Learn how pairing, shorting, ETFs, futures and options can help you reduce the risk in your portfolio.


06/15/07
The Finance Professor: Manage Risk Like a Pro

Learn how to identify, quantify and control potential stock losses.


06/08/07
The Finance Professor: Investments for Grads

Answering your questions on gifts for graduates, how to keep cool when the market's hot, and more.


05/30/07
The Finance Professor: Understanding Risk

Learn about the different forms of risks you might encounter in the market.


08/05/08
Three Internet Stocks That Could Double

These forgotten Internet stocks are being accumulated by hedge funds.


08/15/08
The Five Dumbest Things on Wall Street

Raspberries for Apple; You'll be sorry, UBS; Fortress or Fort Knox? Wholly unappetizing Foods; give Liberty AOL or give them...


08/15/08
McCain Fund-Raising Picks Up

The GOP presidential candidate raised $27 million in July.


08/15/08
Cash-Back Cards Aren't Money in the Bank

Some credit and debit cards give you some cash back on purchases. But you need to manage it well to benefit from it.


Your Recent Quotes: Quote Up0 | Quote Down0
Dow S&P 500 NASDAQ
Oil*
Gold
10 Yr
0.00%
%
%
%
Data delayed 20 min
Sign up for our FREE newsletters now. See All

  • Cramer's Daily Booyah!
  • Before the Bell

Premium Stock Ideas
Access Action Alerts Plus to find out Cramer’s latest picks now!