Derivative Markets

Sessions 11&12

Equity Futures- Cash

and Carry
1. Buy a portfolio of shares that replicates
the stock index( with proportions matching
the construction of the Index and total
value equal to the face value of index)
2. Finance the portfolio by secured
borrowing
3. Sell ONE stock index futures contract
4. Hold the portfolio till the last trading day
, collecting and investing any dividends
received

continued
5. Liquidate the shares IMMEDIATELY when
trading in the future ceases
6. Cash settle the futures contract
7. Use the proceeds of the share sale and
futures settlement to repay the borrowing.

Lets see how the cash-flows work out!

Cash into Shares

During the summer of 2010 the S&P500 index
had fallen from the highs above 1200 reached in
late April and was trading in the 1050-1150 band.
There seemed to be little upward momentum!
Due to this view, an Investment Manager decided
to switch to CASH and placed $10m on deposit to
earn interest fixed @ 0.6% ( 60bps).
The funds were placed on 15 June 10 for 6
months( 15 Dec10)
There is no provision for early withdrawal of
these funds.

We move forward,
thats what we do!
By the end of August with the index having
fallen through 1050 for the fourth time, the
investment manager now expects US share
prices to stage a significant rally and
wishes to benefit from this view.
Investments funds have already been
committed!

?

This is what we do!

He BUYS S&P500 futures in order to profit
from any rise in the market.
On Wednesday 31 Aug 2010 the S&P500
index stands at 1049.33 and the E-mini
Dec 2010 contracts are quoted at 1043.25.
Face Value = $50 x 1049.33 = $52,466.50
Number of contracts=
($10,000,000/52,466.50)=191

Market Prices
On Thursday 15 Dec 2010 , the S&P 500
was 17.7% higher at 1235.23 , while the
December contract traded in a range
1234-1244.25.
The investment Manager was able to close
the futures position at 1234.
We now compare the performance of the
CASH plus FUTURES strategy with the
performance of the Stock Market
itself( index performance) HAD HE
SWITCHED INTO SHARES ON 31 Aug 2010

Results
CASH PLUS FUTURES
$10m + 0.6% interest for 106
days
Profit on Futures:
763 ticksx$12.50x191
contracts
TOTAL

10,017,666.67
1,821,662.50

$11,839,329.17

SHARES
$10m index portfolio + 17.7% 11,771,606.64
capital appreciation
Dividends @ 1.98% for 106
days
TOTAL

58,300.00
$11,829,906.64

Analysis
The two results are within 0.1% of each other.
This demonstrates that the combination of an
interest earning deposit plus the appropriate number
of futures contracts replicates the performance of
the index portfolio very well.
P.S: Results would have been closer had interest
rates not fallen to 0.3% from 0.6% between
Jun&Aug.
If the deposit had been placed at 0.3%( when the
futures contracts were bought) the results would
have been 0.005% of each other!

Starting Block
Stock Index Futures mimic the behavior of the equity
market as a WHOLE and they are EASY to trade
They provide the portfolio manager with a flexible and
effective tool for restructuring an investment portfolio.
Combining a LONG position in CASH ( an interest
bearing deposit) with the requisite amount of stock
index futures will EFFECTIVELY convert a CASH position
into an SHARE position. CASH turns into Shares!
+MONEY MARKET+STOCK INDEX FUTURES=+SHARES

Shares into Cash

Fin17 is evaluating the performance of his
portfolio at the end of April 2010.
Although up 6.4% since the start of the year,
the market as a whole has traded sideways for
the past few weeks and many are of the view
of a temporary downward correction in the
near future.
Fin17 is long 10 different S&P Stocks and
decides to use stock index futures to hedge
his portfolio against such a bear move.

Share portfolio as on
30/4/10
No of
Shares

Share
price($)

Value of
Holding($)

Apple Inc

3,830

251.3

999,974.70

Chevron Corp

12,279

67.86

1,000,001.76

Exxon Mobil

14,756

57.07

1,000,014.12

General
Electric

53,022

14.42

999,994.92

IBM

7,752

123.48

1,000,008.00

J&J

15,552

59.06

999,993.60

JP Morgan

23,486

36.61

1,000,033.88

Microsoft

32,748

23.01

999,960.18

P&G

16,088

59.98

1,000,030.08

Wells Fargo

30,202

25.60

999,988.22

TOTAL

9,999,999.4
6

Portfolio Facts
All the scrips are included in the S&P500 Index
They represent approximately 20% of the weighting
of the Index.
Fin17 decides that his portfolio is sufficiently(?)
representative of the market and that using
Sep2010 E-mini futures will provide an adequate
hedge.
S&P500 Index was at 1186.69 and the full point
value of the futures contract at $50
Face Value of the Index is $59,334.50

Facts continued
Number of contracts needed
$10,000,000/$59,334.50 = 169
contracts
Tell Fin17 what to do.. Buy or sell Futures?

Show me the light!

Fin17 must SELL 169 of the Sep2010
contracts to hedge his position.
She takes your advice and sells at the
market price of 1178.75

Hmm
By the end of June that year , the US Stock
market was down 13% so that Fin17 was
delighted that she had chosen to hedge
her portfolio!
Signs were there that the market was
about to turn so at this point she decided
to square up the hedge.

Analysis
The Share portfolio has shown an overall fall in
value of 13.22%
Average fall in price of shares held of 13.69% and
Dividends received to the equivalent of 0.48% of
the portfolios original value. ( Assumption:
dividends are not re-invested!)
Holdings in GE,Microsoft and Wells Fargo proved
to be the worst performers over the period, each
losing more than 22% over the holding period!

Future , bright!
Futures made money!
On 30 June , Fin17 bought back the
Sep2010 E-mini at 1026.50 resulting in a
profit of 609 tics
609 ticks x $12.50 x 169 contracts = $
1,286,512.50

Total Result
Value of Share Portfolio + Dividends
Received PLUS the Futures Profit =
$9,964,620.10
A small LOSS of 0.35%
If Fin17 had instead decided to liquidate
the shares and invest short term at 0.30%
for 61 days, the fund including interest
would have stood at $10,005,082.79
This would have been a gain of 0.05% over
the period.
Thus, the hedged investment UNDER-

Analyze This!
Combining the long position in shares with
a short futures position did provide a
return close to that of the alternative
money market position, but the results did
not coincide directly.
The 10 shares held actually
underperformed the market in
price( though they outperformed in
dividend yield!)

Starting Gun!
Combining a LONG position in SHARES with
a SHORT position will EFFECTIVELY turn the
SHARES portfolio into CASH.

+SHARES STOCK INDEX FUTURES =

+MONEY
MARKET

Market Analysis
Market fell 13.14% while these particular
shares fell 13.69% an additional loss of
0.55%.
At an annual dividend yield of 1.9% for the
S&P500, the dividends should have been
only 0.33% over the period , but they
actually amounted to 0.48% an additional
profit of 0.15%.
Combining the two gives the net shortfall
of 0.40%.
This explains why the hedged shares

More Analysis( Tracking

Error)
If the shares held had been MORE
representative of the index portfolio the
combination of shares and short futures
would have generated a return close to the
0.05% money market return.
The futures would have been more
effective in turning shares into cash.
If Fin17 had held the index
portfolio( instead of a part) as in the
previous example, a perfect result would
have ensued

Final Word
The Stock Index Futures did a great job in
the end
It turned an un-hedged 13.22% loss into a
0.35% LOSS and saving Fin17 well over
$1m.
Perhaps we need more sophisticated
instruments to hedge portfolios.

We need to study OPTIONS!

Equity Futures vs ETFs

A long-term futures investor might pay
US$5 million, or 5 per cent margin, for a
US$100 million futures contract on the
Standard & Poor's 500 stock index and put
the remaining US$95 million into a money
market mutual fund or other cash
equivalent.
Every few months, as the contract expired,
the investor would have to roll it over into
a new contract. At the end of the year, the
total costs would be US$417,000 for that
US$100 million contract.

Continued
If the underlying index had moved up 5 per
cent during that time, the investor would
net US$4.58 million. If it had moved down
5 per cent, the investor would have lost
US$5.42 million.
If, instead, the same US$100 million were
put directly into an S&P 500 stock index
ETF, the costs would be US$164,000. A 5
per cent increase in the underlying index
would then net the investor US$4.84
million. A 5 per cent drop would cause a
loss of US$5.16 million.