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Derivatives

Derivatives. Lecture 6. Index Futures Strategies. Index Mutual Fund Management Index mutual funds attempt to track the market index It is difficult to track the Market index because the market index… …pays no taxes …incurs no transaction costs …does not experience reinvestment risk

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Derivatives

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  1. Derivatives Lecture 6

  2. Index Futures Strategies • Index Mutual Fund Management • Index mutual funds attempt to track the market index • It is difficult to track the Market index because the market index… • …pays no taxes • …incurs no transaction costs • …does not experience reinvestment risk • Methods used to enhance index mutual fund returns • Index arbitrage • Index futures are often mispriced (1-3% annually) • Create low cost surrogate funds with futures • Long index position allows for low cost arbitrage

  3. Futures Strategies • Example – Commodity Speculation: No Margin You think you know everything there is to know about pork bellies (bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss? Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160 Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290 Loss of 10.23 % = - 5,130

  4. Futures Strategies • Example –Commodity Speculation: With Margin You think you know everything there is to know about pork bellies (bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks @ 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss? Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160 Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290 Loss = - 5,130 Loss 5130 5130 Margin 50160 x.15 7524 ------------ = -------------------- = ------------ = 68% loss

  5. Futures Strategies Cash Substitute Strategy • If you hold cash equivalents, holding futures instead, allows upside potential • Example: If you hold 95% equity & 5% cash, you will underperform the market because cash earns less • Also called “Full Investment Strategy”

  6. Futures Strategies • Cash Substitute Strategy - example --- 95% stocks 5% cash ---100% Stocks Price 0 30 60 90 Time (days)

  7. Futures Strategies Cash Substitute Strategy – example (continued) • Annual returns • Stocks return = 12% • Cash equivalent return = 4% 100% Stock 95% Stock 5% Cash 1.00 x .12 = .12 .95 x .12 = .114 .05 x .04 = .002 .116 12% vs. 11.6%

  8. Futures Strategies Substitution Strategies • Temporary position • Simulate an equity investment with futures (i.e. Hedge Fund) • Accelerate investment process • Similar to “Full Investment Strategy” Example • You manage a mutual fund • End of year causes influx of cash • Goal - keep cash position at minimum • New year is anticipated to produce large outflows

  9. Futures Strategies Example – Accelerate Investment Process • You manage a $25 million mutual fund • Investors send you $3 million in cash, for which you do not yet have investments selected. • Assume the S&P Index contract is currently valued at 1390. • If your mutual fund has a beta of 1.3 and you wish to immediately be fully invested, what will you do?

  10. Futures Strategies Example – Accelerate Investment Process continued • We need to simulate a $3,000,000 investment in our mutual fund (i.e. a long position) 1 S&P contract = 1390 x 250 = $347,500 3,000,000 347,500 11.2 contracts = ------------------------ X 1.3

  11. Futures Strategies Example – Accelerate Investment Process Continued 11 x 347,500 x .15 = $573,375 ANSWER: To be fully invested you need to simulate a $3,000,000 investment. A deposit of $573,375 into a margin account and going long 11 S&P 500 Index contracts will accomplish this goal. This strategy will simulate full investment for your mutual fund.

  12. Futures Strategies Temporary position • The same approach used to “accelerate the investment process” can be used to create a temporary position.

  13. Futures Strategies Simulate an Investment (Hedge Fund) • The same approach used to “accelerate the investment process” can be used to create a hedge fund. • The difference between a simulated investment and an actual investment is • Leverage • Length of investment • Money required

  14. Futures Strategies Underwriter Hedging • Equity underwriters: commission, guarantee or purchase. • A guarantee or purchase an equity issue creates price risk • Risk exists from date of purchase to sale date • Index contracts can be used to hedge risk • Beta is used as the hedge ratio

  15. Futures Strategies Underwriter Hedging – EXAMPLE • On September 1 Merrill Lynch (ML) agrees to buy $10mil of HSE Corporate stock & resell it on Sept 4 • ML estimates a $100/share price • The S&P 500 Index contract is priced @ 1470 • 1470 x 250 = $367,500 • How can ML hedge its risk if HSE has a beta of 0.8? • What is their profit or loss if on Sept 4, they sell HSE @ $90 & close their contract on the S&P contract @ 1290?

  16. Futures Strategies Underwriter Hedging – EXAMPLE - continued • On September 1 Merrill Lynch (ML) agrees to buy $10mil of HSE Corporate stock & resell it on Sept 4 • ML estimates a $100/share price • The S&P 500 Index contract is priced @ 1470 • 1470 x 250 = $367,500 • How can ML hedge its risk if HSE has a beta of 0.8? • What is their profit or loss if on Sept 4, they sell HSE @ $90 & close their contract on the S&P contract @ 1290? 10,000,000 367,500 21.8 contracts = ------------------------ X 0.8 22 contracts

  17. Futures Strategies Underwriter Hedging – EXAMPLE - continued Asset Position Futures Position Start Long stock Short 22 contracts 100,000 x $100= 1470 x 250 x 22 = $10,000,000 $8,085,000 Price drops to $90 Long 22 contracts @ 1350 100,000 x $90= 1290 x 250 x 22 = Finish $9,000,000 $7,095,000 . loss $1,000,000 gain $ 990,000 Net position Gain / Loss = - $ 10,000

  18. Futures Strategies • Futures contracts allow cheap entry & exit from markets • Index contracts can be used to alter portfolio allocation for short periods of time • Use index contracts when large outflows are expected

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