Long stock + Short Futures = Long risk-free bond what is the intuition behind this equation? comments appreciated
Consider the Cash flows of both sides and you can get the following: Return on future contracts = Ft(Future price at time t) - St( spot at time t) = S0(1+Rf)^t - St Return on long stock = St - S0 Add both you get: Return = S0(1+Rf)^t - St + St - S0 To make it easier Take t = 1 ( one year holding period) Return = S0*Rf = risk free return on original investment.
Also need to consider the cost factors. If your port. is long on stock, and you think the market outlook is negative. Instead of selling out all of your stock position (cost $), you can Short Future to creat Risk-Free position. When the outlook get better, you can close out your short future position again. Using future to modify your port. is very cost effective.
great insight guys thx