Chapter 30: Stock Index Hedging Strategies 559 
However, on the last day of trading, the cash-based index product will expire at 
the opening price of the index. If one were to sell out his entire market basket of 
stocks at the current bid prices at the exact opening of trading on that day, he would 
sell his market basket at the calculated last sale of the index. That is, he would actu­
ally be creating the last sale price of the index himself, and would thereby be remov­
ing his position at parity. 
The problem with this is that it is correct theory, but difficult to put into prac­
tice. For example, if one has several million dollars of stocks to sell, he cannot expect 
the marketplace to absorb them easily when they are all being sold at the last minute 
on a Friday afternoon. We will discuss this more fully momentarily, when we look at 
the impact of stock index arbitrage on the stock market in general. 
There is another interesting facet of the arbitrage strategy that combines the 
spread between the near-term future and the next longest one with the idea of exe­
cuting the stock portion of the arbitrage at the close of trading on the day the index 
products expire. Use of this strategy actually allows one to enter and exit the hedge 
without having to lose the spread between last sale and bid or last sale and offer in 
either case. Suppose that one feels that he would set up the arbitrage for 3 months if 
he could establish it at a net price of 1.50 over fair value. Furthermore, if the fair 
value of the 3-month spread is 2.10, but it is currently trading at 3.60, then that rep­
resents 1.50 over fair value. One initiates the position by buying the near-term future 
and selling the longer-term future for a net credit of 3.60 points. At expiration of the 
near-term future, rather than close out the spread, one buys the stocks that comprise 
the index at the last sale of the trading day, thereby establishing his long stock posi­
tion at the last sale price of the index at the same moment that his long futures expire. 
The resultant position is long stocks and short futures that expire in 3 months at a 
premium of 3.60. Since the fair value of such a 3-month future should be 2.10, the 
hedge is established at 1.50 over fair value. The position can be removed at expira­
tion in the same manner as described in the previous paragraph, again saving the dif­
ferential between last sale and the bids of the stocks in the index. Note that this strat­
egy creates buying pressure on the stock market at expiration of the near-term side 
of the spread, and selling pressure at the latter expiration. 
The final way to exit from one's position is to remove it before expiration. 
Sometimes, there are opportunities during the last two or three weeks before the 
futures expire. If one hedged with long stock and short futures, the opportunities 
to remove the hedge arise when the futures trade below fair value - perhaps even 
at an actual discount to parity. If the futures never trade below fair value, but 
instead continue to remain expensive, then rolling to the next expiration series is 
often warranted.