You Are a Portfolio Manager Who Has Just Discovered the Possibilities

question 92

Essay

You are a portfolio manager who has just discovered the possibilities of stock-index futures.Assume that today is January 12.
a. Assume that you have the resources to buy and hold the stocks in the S&P 500. The current level of S&P 500 index is 258.90, the June S&P 500 futures contract is selling for 260.15, the annualized rate on the T-bill expiring on the expiration date of the futures contract is 6%, and the annualized dividend yield on S&P 500 stocks is 3%. Assume that dividends are paid out continuously over the year. Is there a potential for arbitrage, and, if so, how would you go about setting up the arbitrage?
b. Assume now that you are known for your stock selection skills. You have 10,000 shares of Texacola (now selling for 38) in your portfolio, and you are worried about the direction of the market until June. You would like to protect yourself against market risk by using the December S&P 500 futures contract (which is currently at 260.15). If Texacola's beta is 0.8, how would you go about creating this protection?

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Definitions:

Market Neutral

An investment strategy that seeks to avoid some forms of market risk by taking matching long and short positions in different stocks to increase the potential for absolute returns.

Relative Value

A measurement that assesses the worth of an asset by comparing it with the value of similar assets.

Incentive Fees

Fees charged by a fund manager based on the fund's performance, usually a percentage of the investment's earnings above a specified benchmark.

Portfolio Return

The overall gain or loss generated by the collection of investments held by an individual or institution, measured over a specific period.