SHORTING A FORWARD CONTRACT ON THE S&P 500 INDEX. THE PRICE OF...

4. Shorting a forward contract on the S&P 500 index. The price of this transaction is

negotiated between the two parties. Forwards are not liquid, may prove difficult to reverse

once entered, and may involve counterparty risk. Unlike futures, which are standardized

contracts with no customization possible, this alternative has the advantage of

customization; negotiable terms include length of contract, margin requirements, cost of

closing the position early, and timing of payments.

C. i. Because Andrew anticipates an imminent rebound in stock prices, he will want to equitize

his cash position as quickly as possible. Even after transaction costs, the advantages of using

SPDRs or futures (synthetic indexes) far outweigh the cost of holding cash in a rising

market. When a portfolio manager desires to be fully invested, excess cash should be

invested temporarily in an appropriate synthetic equity position until the portfolio manager

can perform stock selection. This strategy will also minimize tracking error.

If a portfolio manager cannot use futures, the manager should use SPDRs to equitize the

cash position. Even with the SPDRs’ management fees and transaction costs, Andrew’s

expected return would be higher by equitizing than leaving the $5 million in cash.

ii. The cost of holding the excess cash in U.S. Treasury bills is:

Cost = cash weight × (S&P 500 return – cash return)

= 0.05 × (12% – 6%)

= 0.30%

iii. The return enhancement of using a futures-based cash management strategy is:

Return enhancement = cash weight × (synthetic index return − cash return)

= 0.05 × (11.8% – 6%)

= 0.29%

Level III: Question 19

Topic: Performance Measurement and Attribution

Minutes: 14

Reading References: