makes money when the index falls. In the previous example, the seller of
the S&P 500 futures contract at 1,400 will lose $2,500 if the index at set-
tlement date rises to 1,410, while he or she would make the same
amount if the index fell to 1,390.
One source of the popularity of stock index futures is their unique
settlement procedure. With a standard futures contract, if you bought it,
you would be obligated at settlement to receive, or if you sold it, you
would be obligated to deliver, a specified quantity of the good for which
you have contracted. Many apocryphal stories abound about how
traders, forgetting to close out their contract, find bushels of wheat, corn,
or frozen pork bellies dumped on their lawn on settlement day.
If commodity delivery rules applied to the S&P 500 Index futures
contracts, delivery would require a specified number of shares for each
of the 500 firms in the index. Surely this would be extraordinarily cum-
bersome and costly. To avoid this problem, the designers of the stock
index futures contract specified that settlement be made in cash, com-
puted simply by taking the difference between the contract price at the
time of the trade and the value of the index on the settlement date. No
delivery of stock takes place. If a trader does not close a contract before
settlement, his or her account would just be debited or credited on set-
tlement date.
The creation of cash-settled futures contracts was no easy matter. In
most states, particularly Illinois where the large futures exchanges are
located, settling a futures contract in cash was considered a wager—and
wagering, except in some special circumstances, was illegal. In 1974,
however, the Commodity Futures Trading Commission, a federal
agency, was established by Congress to regulate all futures trading.
Since futures trading was now governed by this new federal agency and
since there was no federal prohibition against wagering, the prohibitory
state laws were superseded.INDEX ARBITRAGE
The prices of commodities (or financial assets) in the futures market do
not stand apart from the prices of the underlying commodity. If the
value of a futures contract rises sufficiently above the price of the com-
modity that can be purchased for immediate delivery in the open mar-
ket, often called the cashorspot market, traders can buy the commodity,
store it, and then deliver it at a profit against the higher-priced futures
contract on the settlement date. If the price of a futures contract falls too
far below its current spot price, owners of the commodity can sell itCHAPTER 15 The Rise of Exchange-Traded Funds, Stock Index Futures, and Options 257