With an aggregate market value of over $1,000 billion, common stock represents an important fraction of all financial wealth in the United States. This market (which dwarfs the underlying cash markets for existing futures) is also subject to relatively large price volatility. The total risk borne by holders of common stock is enormous.
While this risk has far-reaching effects on investors, market makers and corporations, the possibilities for managing it effectively are, at present, limited. Portfolio diversification permits some reduction in risk for investors who hold balanced portfolios, but since a large portion of every stock’s price variability is due to general market risk, diversification can only reduce risk so far.
A single futures market for contracts on a broad-based stock market index will provide a direct, low cost and effective mechanism for managing market risk in common stocks. However, optimal use of stock index futures in portfolio management must take account of the fact that only a stock portfolio whose composition is identical to the index can be perfectly hedged. In all other cases, index futures will provide what is essentially a cross-hedge.
Stock index futures offer some important possibilities for improving investment performance in actively managed portfolios. They would allow a manager to separate a stock’s market-related performance from its company-specific performance. A manager specializing in stock selectivity could minimize the market risk component in his portfolio by using a short hedge in the futures market. A manager specializing in market timing could adjust his portfolio’s systematic risk level by going long or short in the futures market; he would not have to incur the transaction costs associated with buying and selling individual securities.