To buy or sell CBOT DJIA futures is to buy or sell the DJIA portfolio at some future date.

There are two differences between buying the DJIA portfolio and buying the futures:

(1) The price of the portfolio must either be paid fully in cash or financed at the prevailing short-term rate of interest in a stock margin account.
(2) The owners of the stocks receive cash dividends.

As mentioned earlier, the price of the futures contract closely tracks the price of the index; however, these two differences do have an effect on the futures price. To make the futures contract a true substitute for the index, it is priced to account for both the short-term financing of the stocks and the dividends paid by component stocks until futures expiration. This adjustment is called the cost of carry*, and the price of the DJIA plus the cost of carry determines a fair value (theoretical value) for the futures contract.
The process by which the fair value of the futures contract to the cash index price is maintained is called arbitrage. Arbitrage refers to the simultaneous purchase (sale) of a futures contract and sale (purchase) of the stocks in the underlying index. If the cost of buying the DJIA portfolio and financing the purchase is less than the futures price, arbitragers buy the DJIA portfolio and sell the futures. In doing so, they bring the index and futures prices back in line. Conversely, if the futures price is less than the cost of shorting the stocks, arbitragers short stocks and cover it with a long position in futures. As the expiration date of the futures contract approaches and financing costs decrease, the futures price converges to the price of the DJIA. As previously noted, at expiration the price of CBOT DJIA futures is equal to the Dow.

A position in stock index futures is an efficient method of controlling a portfolio's exposure to stock market risk. Each long or short CBOT DJIA futures contract effectively buys or sells 10 times the DJIA portfolio at the expiration date of the contract. For example, if you are anticipating a correction or downturn in the stock market, selling $200,000 worth of CBOT DJIA futures contracts effectively reduces your current investment in DJIA stocks by $200,000.

If this is your market forecast, why trade in the futures market when you can simply divest yourself of $200,000 worth of stocks? Recall that the futures price is equal to the value of the DJIA plus the cost of carry. One of the components of the cost of carry is a short-term or money market interest rate. By selling the futures contract, the $200,000 now earns the money market rate of return and you guarantee that the future value of your $200,000 investment in stocks will be today's futures price (assuming your portfolio is very similar to the DJIA). Your investment in stocks is now riskless, and your rate of return on this riskless investment is the money market component of the cost of carry. Through the futures transaction, you have decreased your percentage of wealth invested in stocks and increased your percentage of wealth invested in a money market asset. Your underlying asset, the DJIA stocks, remains unchanged, saving you the time and commission expense of selling this substantial portfolio. If your expectations of market performance prove correct, you have shielded the portfolio from loss and gained a money market rate of return.

Of course, buying stock index futures has the reverse effect, meaning that you increase your exposure to equities and decrease your exposure to the money market. Even if you have no prior equity exposure, the same strategies serve to establish a long or short equity position so that you can take advantage of market moves.

Certainly, the same asset allocations and reallocations can be realized by directly buying and selling (shorting) the stocks themselves. Yet it is more expedient and far less expensive to trade stock index futures, particularly if you expect the market upturn or downturn to be short-lived. This is the reason fund managers routinely use stock index futures to change the mix of assets in their portfolios.

In short, the parallel movement between the CBOT DJIA futures and the DJIA makes the futures an ideal way for you to create a proxy of the U.S. market and to restructure and manage the risk of DJIA portfolios, or more generally, portfolios of U.S. stocks. There is no initial investment (other than the initial margin you must post) and little default risk. With a single transaction, you can instantly move in and out of the market at any time and at lower transaction costs than if you had to buy or sell a whole basket of stocks.