Surrogate (pseudo) index

An index used for futures or options can fail its periodic eligibility review — too few constituents, too little turnover, and so on. Normally that would mean the end of derivatives on it.

But if a similar index on another exchange still meets the criteria, the exchange may be allowed to keep offering derivatives anyway, using that similar index as a stand-in. This stand-in is the surrogate, or pseudo, index.

Chapter 6, section 6.3, sets three conditions an index must meet to qualify as a surrogate or pseudo index for a failing index:

• The smaller index (the surrogate) must have at least 80% as many constituents as the larger, failing index.
• At least 50% of the constituent stocks of the larger index must also be part of the smaller index.
• The correlation between the two indices must be at least 0.90, measured over the previous 6 months on a rolling basis.

An index in an exchange is allowed only one pseudo/surrogate index per exchange — an exchange cannot line up multiple substitutes for the same failing index.

Index P, used for derivatives on Exchange X, fails its eligibility review — its turnover has fallen below the required threshold.

Exchange X identifies Index Q, a similar index elsewhere, as a possible surrogate. Index Q has 85 constituents against Index P's 100 (85%, clearing the 80% test), 58 of Index P's 100 stocks also sit in Index Q (58%, clearing the 50% test), and the two indices' returns have shown a 0.93 correlation over the last six months (clearing the 0.90 test). Index Q qualifies as Index P's surrogate, and Exchange X can continue offering derivatives referencing Index Q in Index P's place — but it cannot also line up a second surrogate for Index P at the same time.

Chapter 6, section 6.3, defines the surrogate/pseudo index concept and its three numeric conditions — the 80% constituent-count test, the 50% overlap test and the 0.90 correlation test — immediately after the Product Success Framework exit criteria. Expect a question naming any one of these three thresholds.

• Three separate tests — 80% constituent count, 50% stock overlap, 0.90 correlation — a question can isolate any one of them, and all three must be met together.
• Correlation is measured over 6 months on a rolling basis, the same window used elsewhere in the chapter's eligibility tests.
• Only one surrogate index is allowed per index per exchange — not a shortlist of alternates.