I can’t believe that it’s this late in the came and I am still have trouble with this. Can anyone please be kind enough to explain when you use the synthetic cash equation for the # of contracts Vp[(1+rf)^t]/(pf*mult) and when you actually use the beta equation and set Bt=0? When you hedge a dollar portfolio, doesnt it return the risk free rate? if so, isn’t this the same as creating synthetic cash? I think there is a short in my brain, and something aint clicking. Thanks.
The difference is whether you are Equitizing or Monetizing. 1) If you have cash that needs to be Equitized (to have exposure to the Equity market) then you equation you stated. 2) If you want to want to Monetize (convert to cash) then you use the beta equation and set Bt=0. Hope that helps.
Hi Jbaphna, Thnx for this. But I still dont get it. I get point 1, if you have cash or Tbills that you want to equitize, we find the FV to get the contract #s. But for the 2nd point, are you saying to when they ask you to hedge away market risk, they are not asking you to monetize? ie the result is a risk free asset. Or are you saying that they will need to specifically ask you to create synthetic cash, or else use the beta equation. Thanks.
shanghaiexpo, i was also getting cofused with the aplication of either the beta formula or the Rf formula. According to CFA (Vol 4 pg 363) they will give the same answer if the portfolio is the same as the index that the futures being bought/sold are based on (i.e. if Bp=Bindex for futures). Unfortunately they don’t really give you that info in the exams but i haven’t so far come across a case where they’ve given all data required for both equations and a multiple choice option for both answers or an essay Q where you had the info to do either so i’ve found i’ve always been forced into one or the other by the Q. read pg 363 though as i did find it helpful in explaining the underlying logic of it all
The questions that got me stuck are in volume 2, exam 2 PM #19.1 and 19.4. in 19.4 the betas are different (Bp=.9 and Bf=1) . The answers are close though, just not close enough to get it right even rounding. Hope it shows up in the PM then. Thanks!
Shanghaiexpo re:#2 I am saying that when you hedge away market risk you have effectively monetized i.e. created synthetic cash, you should expect a risk free return from such a position. Monetize = create synthetic cash = hedge away market risk = target/end beta is zero
The beta of the portfolio is not equal to 1 so the formulas will give different results but in 19.4 they specifically say hedging so i would always go with the Beta formula unless they specifically mention wanting to convert to a “synthetic cash” or synthetic equity portfolio. My prob is that they have sometimes used the beta formula when talking about synthetic portfolios (either cash or equity) so in situations where i would use the Rf formula but the Q hasn’t actually given the info needed to use the Rf so it’s been one of those situations i mentioned before where you’re forced into one of the formula