Using futures to gain exposure to an asset

A pension plan would like to use futures to gain exposure to an asset class in advance of the cash receipt from the plan sponsor, which comments are correct?

A: “In this case, it is possible to gain exposure to an asset class by taking long positions in risk free bonds and futures on the asset class.”

B: “A long position in futures on the asset class is sufficient to gain exposure to the underlying asset. Specifically, it is equivalent to borrowing against cash to be received in the future and investing in the underlying asset.”

Aren’t both A and B are correct?

Because the future price is the spot price increased by the risk-free rate, you need to earn the risk-free rate between inception and expiration of the futures contract; the long position in risk-free bonds accomplishes that.

thank you s2000.

i remember in application of derivatives, to hedge the interest rates. they use options. The FV of premium of option is increased by LIBOR.

So now i know future price is increased by the risk free rate.

You’re quite welcome.

May i ask:

The FV option is increased by LIBOR, and future price is increased by risk free rate? What is the reason that different rates are being used?

They aren’t different rates: LIBOR is considered a risk-free rate.

Interesting… you would think interbank lending rates would not be used as a proxy for risk-free rate in the post 2008 era considering the interbank liquidity mess that took place Currently 10 year UK Gilts are yielding 1.08%. 1 year UK Gilt is at 0.11%. and GBP 12 Month LIBOR is at 0.704%… go figure… lol I am guessing the spread between the 1 year LIBOR and 1 year gilt is counterparty risk premium attributed to the financial institutions?

Trying to understand this as to why do we need additional long positions in risk free bond.

First, how would be this position be taken if there is no cash at the moment

Secondly, if lets say 1Mn is expected in future then if we take 1Mn worth of futures exposure on Equity Index now then all the expected cash is utilized.

Are we assuming futures expires on the date cash is received in future.

>> Are we assuming futures expires on the date cash is received in future

i believe so

Ya I’m not sure about the long position in the risk free bond here. We aren’t taking a taking synthetic long position in the asset class. Sounds like this is pre investing so we would not increase the notional amount to be invested by the risk free as the FV.

S2000magician can you clarify the long in a risk free bond. Synthetic long position versus pre investing? Sounds like the latter here.

synthetic long and preinvesting are basically dealt with the same way, in pre-investing they give you the future value you will receive so you don’t have to adjust the numerator (it’s already future valued). Meanwhile if creating synthetic equity, then the present value of cash held needs to be increased at the risk-free rate (i.e. you have to calculate it’s future value), to ensure you have enough funds in the future to settle the long futures contract.

if synthetic long and preinvesting are basically the same,

“In this case, it is possible to gain exposure to an asset class by taking long positions in risk free bonds and futures on the asset class.” - is this statement correct or not?

Yes it’s synthetic investing. Buy bond at Rf and buy a futures worth the FV of that bond.

i checked again, according to the CFA answer, it is wrong. So synthetic wrong and preinvesting are not the same.

A pension plan would like to use futures to gain exposure to an asset class in advance of the cash receipt from the plan sponsor -

“In this case, it is possible to gain exposure to an asset class by taking long positions in risk free bonds and futures on the asset class.” - this statement is not correct.

“A long position in futures on the asset class is sufficient to gain exposure to the underlying asset. Specifically, it is equivalent to borrowing against cash to be received in the future and investing in the underlying asset.” - this is correct.