27a Futures: Adjusting the beta of an equity portfolio

Demonstrate the use of equity futures contracts to achieve a target beta for a stock portfolio and
calculate and interpret the number of futures contracts required

Can I use futures to adjust the beta of my equity portfolio?

 Absolutely.
 Recall that beta is a measure of systematic risk, so if you believe that the market will increase,
you should adjust your portfolio to have a higher beta.

Can't I accomplish that by just buying higher beta stocks?

 You could, but that would be incredibly stupid.

 This is about increasing (or decreasing) the portfolio's exposure to systematic risk, so it makes
the most sense to use equity index futures.
 To INCREASE a portfolio's beta (ie. increase its sensitivity to systematic risk), BUY futures
contracts.
 To DECREASE a portfolio's beta (ie. decrease its systematic risk exposure), SELL futures
contracts.
 The number of futures contracts that should be bought or sold in order to achieve a portfolio's
desired (target) beta can be calculated using the formula on the other side of this page.

Can I use futures to change the nature of my portfolio's assets?

 Yes.
 See 27b and 27c.

Portfolio inputs:
βP = Your portfolio’s current beta

βT = Target beta, or where you would like your portfolio's beta to be

Vp = The current market value of your portfolio

Futures contract inputs:

βf = The beta of the equity futures contract that you will be buying or selling in order to adjust your
portfolio's beta
Pf = The unit price of the futures contract that you will be buying or selling

multiplier = IF APPLICABLE, this is the multiplier applied to each futures contract, but if no multiplier is
provided (in which case, the futures price will likely be 6-digits) then this term has already been included
in Pf

27b Futures: Synthetic equity

Construct a synthetic stock index fund using cash and stock index futures (equitizing cash)

I just got a bunch of cash. Want to come with me to buy an equity index?

 Perhaps you should consider creating a "synthetic" equity position with futures.

What is a "synthetic" equity position?

 A synthetic position is one in which you do not actually hold the underlying equity index, but
you receive the same payoff as if you had.

No thanks. Sounds like something you ivory tower geniuses thought up that has absolutely no
application in the real world.

 Actually, there are some real advantages to a synthetic position, which can save you money
compared to investing directly in the underlying.

I do like money. Tell me about these advantages.

 Compared to directly purchasing the underlying, creating a synthetic equity position has the
advantage of lower transaction costs.
 It is also a more liquid position and what does the curriculum say about liquidity?

Liquidity is ALWAYS good. You should love liquidity more than you love life itself.

 Correct.

Fine, I'll create synthetic equity index position. What do I have to do?

 The first thing you need to do is immediately use this cash to establish a long position in T-bills
(ie. you are lending at the risk-free rate).
Are you HIGH? I just told you that I want a synthetic equity index position. I don't want to lend my
money to the government. This is complicated. I'm just going to buy the index.

 It wouldn't be very "synthetic" if you just bought the index, would it?
 So you'd miss out on all those advantages that we just discussed.
 Remember, you do like money, right?

Okay, I lend my money to the government. Now I have no cash. How am I supposed to establish a
position in anything?

 It's a 4-step process.

 Actually, the curriculum talks about a two-step process, but I'm going to add a couple just to be
clearer, so don't get confused.
 Step 1: Determine the unrounded number of equity futures contracts to enter using this
formula:

Unrounded # of futures contracts = [(Valuecash)(1+Rf)] / [(Pf)(multiplier)]

 Note that Pf is simply the price of the relevant futures contract.

 Also, if the contract multiplier is given, it has already been included in the contract price.

Oh, is this the same formula that we discussed in 27a?

 NO. NO. NO. NO. NO NO. NO. NO.

No?

 Well, yes (but it's been modified a bit).

 Assume that it's a different formula because this LOS is not modifying the beta of your existing
portfolio, which is what we did in 27a.
 This is about using futures to covert cash to equity for a specific period without ever having to
buy equities.
 Remember, Synthetic equity = Long risk-free bond + Long equity futures
 Because the government is going to pay you interest on the T-bills you are holding, you will be
able to go long more equity futures contracts that you would if your money wasn't growing at
the risk-free rate (Rf).
 Note also that, unlike the formula in 27a, BETA does NOT appear in this formula.
 NEVER FORGET THIS.

Okay, I won't forget it. Calm down. What's next?

 I swear, if you forget this, I will beat you senseless.

 Step 2: Round the number of contracts to the nearest integer.

Can I use partial contracts?

 You may NOT use partial contracts.

Fine. What's next?

 Step 3: Calculate how much cash you need today to buy your futures at time t.
 Essentially, find the present value of the cash you will use to settle your long equity
futures position at time t using this formula:

PV of futures contracts = [(# of contractsrounded)(Pf)(multiplier)] / (1+Rf)

 NOTE: This is nothing more than a re-statement of the above formula, but it's using the
rounded number of contracts that you determined in Step 2.

I think I've got it. So, Step 4 is to calculate the number of shares that I will be acquiring at time t, right?

 Yes.

And to do that, I just multiply the number of contracts by the multiplier, right?

 NO. NO. NO. NO. NO NO. NO. NO.

 Because you will not be receiving any dividends, you need to discount the number of contracts
by the dividend yield using this formula:

Effective number of shares purchased = [(# of contractsrounded)(multiplier)] / (1+d)t

 Note that d is the dividend yield on the index for which you buy a futures contract.
 Note also that you may be told to ignore the dividend yield, but be prepared for it just in case.

27c Futures: Synthetic cash

Explain the use of stock index futures to convert a long stock position into synthetic cash

If I can create a synthetic equity futures position using cash, can I create synthetic cash using my
equity portfolio?

 Yes.
 As we discussed in 27b, synthetic equity can be created by lending at the risk-free rate and
taking a long position in equity index futures contracts.
 Or, Stock = Futures + Rf
 When we say "cash" (in the context of derivatives), we are taking about the risk-free rate.
 Which means that the above formula can be rearranged as: Rf = Stock - Futures
 Since there is a negative sign in front of futures, it means that we are SELLING futures contracts.
 But you would have known that anyway because cash (or Rf) has a beta of 0, which means that
we want to reduce the beta of our equity portfolio (or perhaps just part of it) from whatever it is
now to 0.
Which formula should I use to "cashify equity"?

 Cute.
 You may have seen a formula like the one below, which tells you the approximate number of
futures contracts you'll need to use:

Vp = Portfolio value

Pf = futures price

rf = risk-free rate

T = time period

Then we round that number to the nearest integer, right?

 Yes.
 Then calculate the value of the equity that you'll be converting using the following formula:

And that's it?

 No, then divide by (1 + d)T - like in 27b - to get the number of units of equity that are being
converted to cash.

27d Futures: Adjusting portfolio allocation

Demonstrate the use of equity and bond futures to adjust the allocation of a portfolio between equity
and debt

Can I really adjust the allocation of my stock/bond portfolio using futures contracts?

 Yes, futures can do that as well.

Is there anything futures can't do?

 I doubt it.

So, how do I do it?

  Recall from 27a the basic equation for determining the number of futures contracts required to
achieve your portfolio's desired beta is:

So, do I do the same thing with bond futures contracts?

 Almost, but there are two key differences.

1. A bond portfolio does not have a beta, it has a (modified) duration.

2. You MUST remember to adjust the number of contract with the yield beta.

Yield beta? What's that?

 DAMMIT, I don't have time to tell you.

 Look it up in the curriculum if you care.
 Just remember to use it if it's given to you - otherwise assume that it's 1.0.
 The formula for adjusting your bond portfolio looks like this:

where:
Vp = current value of the portfolio
Pf = futures price
MDT = target (desired) modified duration
MDP = modified duration of the portfolio
MDF = modified duration of the futures

The formula that you just gave me looks a lot like the formula from 23e.

 That's because it is similar, but make sure you use futures when you need to use futures and the
CTD bond when you need to use the CTD bond.

Now that I have the formulas, how do I use them to reallocate my stock/bond portfolio?

To reallocate an amount from equity to bonds:

1. Remove all systematic risk from the position (beta = 0) by shorting equity futures.
2. Add duration to the position (MD > 0) by going long bond futures.

To reallocate an amount from bonds to equity:

1. Remove all duration from the position (MD = 0) by shorting bond futures.
2. Add systematic risk to the position (beta > 0) by going long equity futures.
What if I want to change my allocation AND the beta or MD?

 You can do this the same way as described above.

 Just remember to net out the number of contracts.

27e Futures: Exposure to new asset classes

Demonstrate the use of futures to adjust the allocation of a portfolio across equity sectors and to gain
exposure to an asset class in advance of actually committing funds to the asset class

Now that you've taught me how to adjust the allocation of my stock/bond portfolio using futures
(see 27d), I'm wondering if I can use futures to gain exposure to new asset classes. Can I?

 I told you, futures can do ANYTHING.

 Imagine that you have a portfolio of 100% equities valued at $1,000,000 and you would like to
diversify into a new asset class
 You decide that you would like your portfolio to behave as if it were 70% equities and 30% gold
 This can be accomplished by following these steps:

1. Determine the amount of your portfolio that needs to have its risk exposure adjusted (ie. $1m x
30% = $300,000)
2. Convert this amount of your portfolio's equity into synthetic CASH by shorting equity futures
contracts using the beta adjustment formula from 27a:

3. Convert this amount of synthetic cash into gold by purchasing gold futures contracts

NOTE: Pf is not the full value of your portfolio (ie. $1m), but only the portion for which you want to
change the risk exposure (ie. $300,000)

NOTE: When converting equities into synthetic cash, your target beta is 0

NOTE: This process is virtually identical to that described in 27d.

What is Pre-investing?

 Imagine that you have a portfolio of 100% equities valued at $700,000

 You are expecting a cash payment of $300,000 (cash) you would like to take this opportunity to
diversify your portfolio into 70% equities and 30% gold
  Using the same process described above, but treat the expected $300,000 cash as if it were a
distinct portfolio (which it essentially is)
 Ideally, the timing of expected payment should correspond exactly with the expiry date of your
futures contract

27f Futures: Hedging exchange rate risk

Explain exchange rate risk and demonstrate the use of forward contracts to reduce the risk associated
with a future receipt or payment in a foreign currency

Don't tell me there's even MORE that you can do with futures.

 There is.
 Specifically, if you are expecting to receive a foreign currency-denominated payment, you can
use futures to hedge exchange rate risk.
 Imagine you are an American exporter who has made a big sale to a Belgian client.
 You are expecting a large euro-denominated payment and, since you have already booked this
sale as income.
 You would like to convert these euros into dollars as soon as the payment is received (preferably
at the exchange rate that was used to record the sale) in order to avoid a large write-down
when it gets converted into cash on your balance sheet.
 This is known as Transaction risk exposure and it can be hedged using forward contracts.
 Before hedging, you are expecting to receive a large payment of euros on day x, which makes
your starting position Long euros.
 So you go to a dealer and ask for two forward contracts: one to sell euros, and another to buy
dollars (both will be executed on day x).

Hedging transaction risk exposure with forward contracts:

Imagine you are an... Default Position Required forward contracts

Exporter expecting a large FC- Long FC Sell (short) FC
denominated payment Buy (long) DC
Importer with a large FC- Short FC Buy (long) FC
denominated payment due Sell (short) DC

27g Futures: Hedging exchange rate risk

Explain the limitations to hedging the exchange rate risk of a foreign market portfolio and discuss
feasible strategies for managing such risk
So, now that I know how to hedge exchange rate risk for a one-time foreign currency-denominated
payment (see 27f), I'm wondering if I can use futures contracts to hedge exchange rate risk for my
foreign investments. Can I?

 Yes, but it is more difficult to hedge exchange rate risk for a foreign investment than it is for a
one-time payment.
 When you invest in a foreign market equity, you are assuming two basic types of risk:

1. Market risk, which is no different than the equity risk associated with investing in a domestic
equity (ie. it might go up, or it might go down)
2. Exchange Rate risk, which is related to shifts in the relative values of your domestic currency and
the foreign currency in which your investment is denominated.

What strategy should I use to hedge market and exchange rate risks for a foreign investment?

 The answer to that question depends on your expectations for the future.

Of course it depends on my expectations for the future. If I could predict the future, I wouldn't need
to learn any of this stuff.

 Good point.
 Let's assume that by "foreign investment" you mean a foreign market's equity index.
 As I mentioned, any foreign investment is exposed to both market risk and exchange rate risk.
 If you choose not to hedge either market risk or foreign exchange risk, each of these risk
exposures could work for you, or against you, or they could offset each other.
 For example, a gain in local currency terms could be wiped out if the local currency depreciates
relative to your domestic currency
 Alternatively, you could hedge one or both of these risks:

Strategy Required transactions Impact on return

Hedge market risk, Sell (short) futures contracts on the You will earn the FOREIGN risk-free
Don't hedge foreign market index (if such contracts rate.
exchange rate risk exist)
Hedge market risk, Sell (short) futures contracts on the You will earn your DOMESTIC risk-free
Hedge exchange foreign market index, AND sell (short) a rate.
rate risk forward contract for the value that you
expect your investment to be worth (in
FC-terms) on day x

Are there any limitations to hedging foreign investment risks?

 There may be short-term factors that justify hedging the risk of a foreign market, but you likely
made this investment in the first place because it offered a better risk/return profile than any
possible investments in your domestic market, so it doesn't make sense to hedge this away.
 Foreign exchange rates should revert to their equilibrium level over the long-run, so it makes
little if any sense to hedge exchange rate risk (except, again, in the very short-term, such as if
you are expecting a large FC-denominated payment - see 27f).