Equity derivative

Equity derivatives are products designed to profit from changes in the value of Equity indices. They fall into two broad classes

• Listed futures and options on different global equity indices
• Over the counter (OTC) forwards and options

Equity index futures and options tend to be in liquid markets for close to delivery contracts. They trade for cash delivery, usually based on a multiple of the underlying index on which they are defined (for example £10 per index point).

OTC products are usually for longer maturities, and are usually a form of options product. For example, the right but not the obligation to cash delivery based on the difference between the designated strike price, and the value of the designated index at maturity. These are traded in the wholesale market, but are often used as the basis of guaranteed equity products, which offer retail buyers a participation if the equity index rises over time, but which provides guaranteed return of capital if the index falls. Sometimes these products can take the form of exotic options (for example Asian options or Quanto options).

Forward prices of equity indices are calculated by computing the cost of carry of holding a long position in the consitutuent parts of the index. This will typically be

• the risk free interest rate, since the cost of investing in the equity market is the loss of interest
• minus the imputed dividend yield on the index, since an equity investor receives the sum of the dividends on the component stocks. Since these occur at different times, and are difficult to predict, estimation of the forward price is something of an art, particularly if there are not many stocks in the chosen index.

Indices for futures are the well-established ones, such as S&P, FTSE, DAX, CAC40 and other G12 country indices. Indices for OTC products are broadly similar, but offer more flexibility.