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ne of the significant innovations of the 1980s is the introduction of stock index futures contracts. Despite some controversy about index arbitrage and program trading that developed after the October stock market crash in 1987, these contracts are very successful and beneficial to stock portfolio managers. Institutional investors use stock index futures as a major trading tool. Hedging through trading futures is a process used to control or reduce the risk of adverse price changes. Until 1982, market participants could not control market risk of their portfolios. The introduction of stock index futures contracts offers them an opportunity to manage the market risk of their portfolios without changing the portfolio composition. The objective of hedging is to minimize the risk of the portfolio for a given level of return. Index futures is favored as a hedging vehicle because of its liquidity, speed, and lower transaction costs, including bid-ask spread and brokerage commissions. Factors that influence the hedge construction and its effectiveness include basis risk, hedging horizon, and correlation between changes in the futures price and the cash price. The application of portfolio theory to hedging has attracted a great deal of attention from academics and market participants. Johnson
The Journal of Futures Markets – Wiley
Published: Oct 1, 1993
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