The volatility of a stock index falls sharply, the index drops in value, and its expected return increases. Assuming all else (dividend yield, interest rates, etc.) are constant, which of the following is true?
A) The futures price on the index increases because of the increased expected return on the index.
B) The futures price decreases because of the drop in the level of the index.
C) The futures price stays the same because the drop in the level of the index is negated by the increased expected return.
D) The futures may increase, decrease or stay the same depending on the extent of fall in volatility relative to the increase in expected returns.

Question

Quizplus · Accepted Answer

The drop in the level of the index will generally result in a decrease in the futures price. Option A is incorrect because increased expected return does not necessarily result in an increase in futures price. Option C is incorrect as the drop in the level of the index is not negated by an increase in expected return. Option D is partially correct as the futures price may increase, decrease or stay the same, but it is not accurate to state that it depends on the extent of the fall in volatility compared to the increase in expected return.

The Volatility of a Stock Index Falls Sharply, the Index