I’m confused on what’s happening here. Suppose PM has $50 mill portfolio in US large cap and wants to create synthetic cash. He sells X amount of futures in S&P 500, and receives the cash in 3 months or whenever.
My question is, how does he enter that position and what will he be delivering in 3 months? I assume he must put forth margin, is he selling stocks in his portfolio to get that margin? In 3 months, if he receives the 50 million (plus risk free rate) in cash, doesn’t he need to deliver the contracts? Where is he getting the money to purchase those contracts to deliver?
Either the text isn’t doing a great job of explaining this, or my brain is fried.
Edit: I’m assuming your large cap portfolio is not identical to the basket on S&P 500 futures contract. But my point is, if you want the cash in 3 months, are you not going to have to deliver/sell all those securities in 3 months (ie. the very problem you were trying to avoid - selling all stocks - to begin with?)
the motivation of creating synthetic cash is you expect equity to be down for short term, but you don’t want to sell your equity because you still want to keep your equity.
so you sell futures contract and and you get cash. When futures contract expires, you get cash return at risk free rate over the short term duration, and you still own the stock.
It sounds more like you’re simply hedging any equity losses on your equity portfolio - ie. you’ll receive any cash on the futures settlement IF the stocks depreciated. This will likely only be a fraction of the value of your equities portfolio. Seems far different than “creating synthetic cash”, unless, again, I’m missing something. Only way you receive the cash = to your portfolio is if the futures contracts require actual delivery, which means you deliver all your securities at expiration, which doesn’t seem any different that the hassle of liquidating all of your securities.
There is more than one way for a portfolio manager to increase exposure to stocks, or equities. The most obvious way is to just buy equities.
Another way is to take long positions in equity futures contracts. Portfolio managers prefer this latter method because 1) transactions costs are lower when trading futures contracts and 2) the portfolio is able to preserve liquidity because the manager only has to maintain the futures exchange’s margin requirement, which is much lower than the total dollar value of the securities underlying the futures contracts.
When constructing a generic synthetic equity position, the portfolio manager uses cash to buy risk-free bonds and takes a long position in equity futures contracts. If the portfolio manager already has a position in risk-free bonds, she can just add the contracts. This combination of bonds and futures replicates the performance of the equity without actually having an equity position. Hence, synthetic equity.
Synthetic Cash - would be when you take a short position in Equity Futures Contracts, Sell Risk Free Bonds … I guess … then
Shoot -I think your qn is more on the lines or how trading futures is different from trading underlying;
cpk correct me if I am wrong
trading futures only involves posting the net of the futures position vs the underlying (if 339 contracts, 339x(St-S0)x multiplier) on a daily basis or so as opposed to liquidating the entire position say $50m worth position in the stock per se.
so to reinforce when ur outlook for a short term is not bright, you use fractional cash to mimic buying a bond by having net of positions (equity, futures) deliver risk free rate @ the end of your outlook horizon i.e. 2mo etc.
I think I was just getting confused at the title “Creating Cash out of Equity” - and thinking the idea was to actually convert the equities portfolio to cash, when it doesn’t really have anything to do with that. You’re simply hedging the value of your equities portfolio for a period of time and allowing it to proxy as cash during that time. That is, you won’t receive any actual cash from this strategy in 3 months (aside from a net payment if the index value falls below your futures contract price that you originally sold).
Lol, I know. BUT, in my defense as mentioned, title of section in CFAI text is called “Creating Cash out of Equity”, so it’s convenient for me to blame them for my brain lapse lol
EOC #2B from Reading 26 - solution suggests investor bought Index Futures to get exposure with his $300 M, but at contract expiration, he had to deliver the cash, and received the index stock units. So obviously delivery is assumed in THIS question/strategy, but with creating synthetic cash strategy, there’s an underlying assumption that it’s cash settled (not delivered) - otherwise it would severely impair liquidity as investor trying to create synthetic cash would actually have to go find the money to purchase futures index contracts at delivery to deliver. I just feel like text does a poor job of telling us how this stuff happens in practice. Some questions/strategies delivery is assumed, and others cash settlement is assumed? Maybe I’m missing something again though…