Unit 10: The Financial Advisor’s Case Futures to Defer

One of your most sophisticated , Joseph DeLuca, believes that the market will decline and hence reduce the value of his substantial portfolio. However, he does not want to sell the , because the sales would generate a substantial federal capital gains liability in the current tax year. He recently read that futures may be used to reduce the risk of loss from price changes as well as vehicles designed to speculate on price changes. You have been his personal financial planner for many years, and he has asked you to develop a strategy using futures to achieve his goal of protecting his gains without selling the securities in the current year.

Since DeLuca has a in stocks, you realize that he needs a position in futures to reduce the risk of loss. Since his portfolio is both substantial and well diversified, you decide to limit your choices to index futures. The portfolio is worth several million dollars, but you decide to use $1,000,000 as the basis for all comparisons since any other amount could be expressed as a multiple of $1,000,000. You notice that an index of the market is 100 and there exists a with a value that is 500 times the index. The margin requirement is $2,000 per contract. You decide that the best means to explain the strategy using futures is to answer a series of questions that illustrate how the futures may be used to meet DeLuca’s goal of deferring the tax obligation until the next year while protecting his gains, These questions are as follows:

1. What is the value of the contract in terms of the index?

2. How many contracts would DeLuca have to sell to $1,000,000? Why should DeLuca sell rather than purchase the contracts?

3. How many will DeLuca have to put up to meet the margin requirement? If the annual on securities is 6 percent, what is the interest lost from the margin requirement if the position must be maintained for two months?

4. If the market declined by 5 percent, what will happen to the value of the contracts? Could DeLuca take funds out of the position to reduce the lost?

5. If the beta of his portfolio is 1.0 and the market declines by 5 percent, how much would he lose on a $1,000,000 portfolio?

6. If the beta of the portfolio were less than 1.0, could DeLuca take funds out of the position to reduce the interest lost?

7. Suppose the beta of the portfolio is 0.75 and DeLuca sells 15 contracts. The market then rises by 10 percent; what are the profits and losses on the portfolio and on the contracts? What is the net profit or loss?

8. When the contracts expire, will DeLuca have to deliver the securities he owns to cover the contracts?

9. Does the strategy of using futures contracts achieve its objective?

Answer:

This problem is designed to illustrate how a futures contract may be used in addition to speculating. DeLuca does not want to sell his position in stock because the sale would result in tax obligations this year. By establishing a short position in the futures contract, he is able to protect himself from a decline in the price of his stock. This hedging strategy permits him to transfer any gains on the sale of stock to the next taxable year.

1. The value of the contract in terms of the index: 100 x $500 = $50,000

2. a. Number of contracts that must be sold: $1,000,000/$50,000 = 20 contracts

b. Since DeLuca owns $1,000,000 worth of stock, he must take a short position (i.e., sell) in the futures contract in order to hedge. If the value of the stock declines, the value of the short position in the futures rises, so that the decline in the value of the stock is offset by the profit on the short position in the futures. (If DeLuca purchased the contract, he would have two long positions and would lose on both if stock prices fell.)

3. The margin requirement is $2,000 per contract, so DeLuca will have to remit $40,000. The lost interest for two months is $40,000 x .06 x (2/12) = $400. (This answer assumes simple interest.) 4. If the market declines by 5 percent, the value of each contract declines by 5 percent (if the contracts move exactly with the market) to $47,500. DeLuca earns $2,500 per contract on his short position for a total of $50,000. Since he is meeting his margin requirement, the $50,000 may be removed

251 from the account and the funds invested to offset the interest lost.

5. If the portfolio's beta is 1.0 and the market declines by 5 percent, the value of a $1,000,000 portfolio should decline by 5 percent (i.e., a $50,000 loss). Presumably by hedging, the $50,000 loss on the portfolio is offset by the $50,000 gain on the short position in the futures contracts.

6. If the portfolio's beta is less than 1.0, that implies the value of the portfolio will fluctuate less than the market. Fewer contracts would be needed to hedge the portfolio.

7. If the market rises by 10 percent to 110, the value of a contract becomes 110 x 500 = $55,000. DeLuca sustains a $5,000 loss on each contract for a total loss of $100,000, which exactly offsets the gain on the portfolio. However, the loss on the futures exceeds the margin deposit, and DeLuca will have to deposit an additional $100,000 to meet the margin requirement. Meeting this additional margin requirement increases the interest cost of hedging.

8. When stock index futures contracts expire, settlement occurs in cash, so DeLuca will not have to deliver his securities.

9. Since losses on the portfolio are offset by gains on the futures contracts (and vice versa for gains on the portfolio being offset by losses on the futures), the objective is achieved.

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