Having a hard time with this sub-topic. One example is in Schweser, Study Sesh 15, Reading 41, Creating synthetic equity (page 145 of book 3). The math is straight forward but I am not sure what is really going on here. The PM has T-Bills and wishes to create a synthetic equity position for the next six months. Is this question simply asking how many contracts the PM can get by dumping his bills, and buying the S&P futures? Am I retarded?
It’s a bit different. Unless you count margin requirements, you don’t need to put cash down to take a long position in futures, since only the difference settles at expiration. So, there’s really no meaning to selling the bills to buy futures. Furthermore, the return of futures is not the same of the return of the actual equities. Since futures don’t lock up your cash, they do not result in opportunity costs like holding equities does. Naturally, this opportunity cost is reflected in the futures prices and is related to the risk free rate minus dividends (this is in the L3 syllabus). The “synthetic equity” position that you described is meant to replicate the payoff from holding the actual equities. The return difference between the futures and equities is offset by the accretion of the T-bills. Anyway, I hope this helps. It’s a good question.
This does help. Thank you. But I’m still not confident in the mechanics of the trade. Tell me if I have this straight: By holding the futures, I don’t collect any of the dividends that I would if I just went long the stock. But going long the stock probably means incurring a large transaction fee and might take time to execute all of the necessary trades. I can gain the same exposure by entering the futures contract and taking the money it would cost me to buy the underlying and instead investing it in T-Bills. The yield I recieve on the bills will offset the dividends that I do not recieve and do not re-invest, thus creating the same position synthetically as I would if I actually went long the stock. The calculations in the example on page 145 of book 3 (schweser) tell me how many contracts I need to buy. Do I have it or am I missing something? Thanks
You have the correct general idea. Transaction costs are the primary reason that you would do the synthetic equity position, as opposed to just selling your T-bills and buying stock. To clarify the trade mechanics, consider that these two positions are equivalent: 1) Stock only. You get stock return + dividends. 2) T-bills and long futures. The T-bills give you the risk free rate. The futures give you the stock return + dividends - the risk free rate. The sum is the stock return + dividends. Note that the risk free rate and the “dividends” from the futures are reflected in the futures price. You lose the risk free rate from stock futures since the basis (difference between spot price and futures price) will converge to zero. You “gain” the dividend payments from futures, because futures prices will be discounted relative to spot prices to reflect this under a no-arbitrage environment. In the synthetic equity position, the futures price discount (not the T-bill yield) will offset the dividends that you will not receive.
Cool. That is great. What about re-investing dividends? Is that accounted for anywhere?
thought holders of equity futures were not entitled to dividends?
ChrisV Wrote: ------------------------------------------------------- > Cool. That is great. What about re-investing > dividends? Is that accounted for anywhere? This is reflected in the futures price. Futures prices assume that you invest the dividends at the risk free rate. That’s why you need to deduct the present value of the dividends to get the futures price from the spot price. “thought holders of equity futures were not entitled to dividends?” Long futures holders are not entitled to the dividends. However, they are compensated for this by a lower futures price relative to the spot price.