Investment and Portfolio Management

TOPIC 10 – TUTORIAL 10

1. Why is there no futures market in cement?

There is little hedging or speculative demand for cement futures, since cement prices are fairly
stable and predictable. The trading activity necessary to support the futures market would not
materialize. Only those commodities and financial securities with significant volatility tend to have
futures contracts available for hedgers and speculators.

2. Why might individuals purchase futures contracts rather than the underlying asset?

The ability to buy on margin is one advantage of futures. Another is the ease with which one can alter
one’s holdings of the asset. This is especially important if one is dealing in commodities, for which the
futures market is far more liquid than the spot market.

3. Are the following statements true or false? Why?

a. All else equal, the futures price on a stock index with a high dividend yield should be higher
than the futures price on an index with a low dividend yield

b. All else equal, the futures price on a high-beta stock should be higher than the futures price
on a low-beta stock.

c. The beta of a short position in the S&P 500 futures contract is negative

a. False. For any given level of the stock index, the futures price will be lower when the
dividend yield is higher. This follows from spot-futures parity:
F0 = S0 (1 + rf – d)T

b. False. The parity relationship tells us that the futures price is determined by the stock price,
the interest rate, and the dividend yield; it is not a function of beta.

c. True. The short futures position will profit when the S&P 500 Index falls. This is a negative
beta position.
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4.

a. Turn to the Mini-S&P 500 contract in Figure 22.1. If the margin requirement is 10% of the
futures price times the contract multiplier of $50, how much must you deposit with your
broker to trade the September maturity contract?
b. If the September futures price were to increase to 2,090, what percentage return would you
earn on your net investment if you entered the long side of the contract at the price shown
in the figure?
c. If the September futures price falls by 1%, what is your percentage return?

a. The closing futures price for the September contract was 2082.70, which has a dollar value
of:
$50 × 2082.70= $104,135
Therefore, the required margin deposit is: $10,413.5

b. The futures price increases by: 2090 – 2082.7 = 7.3

The credit to your margin account would be: 7.3 × $50 = $365
This is a percent gain of: $365/$10,413.5 = 3.51%
Note that the futures price itself increased by only 0.35%.

c. Following the reasoning in part (b), any change in F is magnified by a ratio of (l /margin

requirement). This is the leverage effect. The return will be –10%.

5. a. A single-stock futures contract on a non-dividend-paying stock with current price $150 has
a maturity of 1 year. If the T-bill rate is 3%, what should the futures price be?

b. What should the futures price be if the maturity of the contract is 3 years?
c. What if the interest rate is 6% and the maturity of the contract is 3 years?

a. F0 = S0(1 + rf ) = $150 × 1.03 = $154.50

b. F0 = S0(1 + rf )3 = $150 × 1.033 = $163.91

c. F0 = 150 × 1.063 = $178.65

 Investment and Portfolio Management

6. Suppose the value of the S&P 500 stock index is currently 2,000.

a. If the 1-year T-bill rate is 3% and the expected dividend yield on the S&P 500 is 2%, what
should the 1-year maturity futures price be?

b. What if the T-bill rate is less than the dividend yield, for example, 1%?

a. F0 = S0 × (l + rf – d) = 2,000 × (1 + 0.03 – 0.02) = 2,020

b. If the T-bill rate is less than the dividend yield, then the futures price should be less than the
spot price.

7. OneChicago has just introduced a single-stock futures contract on Brandex stock, a company
that currently pays no dividends. Each contract calls for delivery of 1,000 shares of stock in 1
year. The T-bill rate is 6% per year.

a. If Brandex stock now sells at $120 per share, what should the futures price be?

b. If the Brandex price drops by 3%, what will be the change in the futures price and the change
in the investor’s margin account?

c. If the margin on the contract is $12,000, what is the percentage return on the investor’s position?

a. $120 × 1.06 = $127.20

b. The stock price falls to: $120 × (1 – 0.03) = $116.40

The futures price falls to: $116.4 × 1.06 = $123.384
The investor loses: ($127.20 – $123.384) × 1,000 = $3,816

c. The percentage loss is: $3,816/$12,000 = 0.318 = 31.8%

8. The multiplier for a futures contract on a stock market index is $50. The maturity of the contract
is 1 year, the current level of the index is 1,800, and the risk-free interest rate is .5% per month.
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The dividend yield on the index is .2% per month. Suppose that after 1 month, the stock index
is at 1,820.

a. Find the cash flow from the mark-to-market proceeds on the contract. Assume that the parity
condition always holds exactly.

b. Find the holding-period return if the initial margin on the contract is $5,000.

a. The initial futures price is F0 = 1800 × (1 + 0.005 – 0.002)12 = 1,865.88

In one month, the futures price will be:
F0 = 1820 × (1 + 0.005 – 0.002)11 = 1,880.97
The increase in the futures price is 15.09, so the cash flow will be:
15.09 × $50 = $754.45

b. The holding period return is: $754.45/$5,000 = 15.09%

9. The S&P portfolio pays a dividend yield of 1% annually. Its current value is 2,000. The T-bill
rate is 4%. Suppose the S&P futures price for delivery in 1 year is 2,050. Construct an arbitrage
strategy to exploit the mispricing and show that your profits 1 year hence will equal the
mispricing in the futures market.

The parity/theoretical value of F is: 2,000 × (1 + 4% – 1%) = 2,060

The actual futures price is 2,050, lower by 10.
ð Futures are currently underpriced + Stocks are currently overpriced
Arbitrage Portfolio CF now CF in 1 year
Short stocks + S0 - (ST + S0 * d)
Long futures 0 ST - F0
Lend - S0 + S0 * (1 + rf)
Total 0 S0 * (1 + rf) - F0 - S0 * d = 10
 Investment and Portfolio Management

Extra Exercises:

1. What is the difference in cash flow between short-selling an asset and entering a short futures
position?

Short selling results in an immediate cash inflow, whereas the short futures position does not:
Action Initial CF Final CF
Short sale +S0 –ST
Short futures 0 F0 – ST

2. Determine how a portfolio manager might use financial futures to hedge risk in each of the
following circumstances:

a. You own a large position in a relatively illiquid bond that you want to sell.

b. You have a large gain on one of your Treasuries and want to sell it, but you would like to

defer the gain until the next tax year.

c. You will receive your annual bonus next month that you hope to invest in long-term corpo-

rate bonds. You believe that bonds today are selling at quite attractive yields, and you are

concerned that bond prices will rise over the next few weeks.

a. Take a short position in T-bond futures, to offset interest rate risk. If rates increase, the

loss on the bond will be offset to some extent by gains on the futures.

b. Again, a short position in T-bond futures will offset the interest rate risk.

c. You want to protect your cash outlay when the bond is purchased. If bond prices
increase, you will need extra cash to purchase the bond. Thus, you should take a long futures
position that will generate a profit if prices increase.