A fund manager has a portfolio worth $100 million with a beta of 1.5. The manager is concerned about the performance of the market over the next two months and plans to use three-month futures contracts on the S&P 500 to hedge the risk. The current level of the index is 2250, one contract is on 250 times the index, the risk-free rate is 2%, and the dividend yield on the index is 1.7% per year. (Assume all the rates are continuously compounded.) What is the theoretical futures price for the three-month futures contract? What position should the fund manger take to eliminate all exposure to the market over the next two months? Calculate the effect of your strategy on the fund manager’s returns if the level of the market in two months is 2,000, 2,200, 2,500, 2,800, and 3,000.
Risk and return
Before understanding the concept of Risk and Return in Financial Management, understanding the two-concept Risk and return individually is necessary.
Capital Asset Pricing Model
Capital asset pricing model, also known as CAPM, shows the relationship between the expected return of the investment and the market at risk. This concept is basically used particularly in the case of stocks or shares. It is also used across finance for pricing assets that have higher risk identity and for evaluating the expected returns for the assets given the risk of those assets and also the cost of capital.
A fund manager has a portfolio worth $100 million with a beta of 1.5. The manager is concerned about the performance of the market over the next two months and plans to use three-month futures contracts on the S&P 500 to hedge the risk. The current level of the index is 2250, one contract is on 250 times the index, the risk-free rate is 2%, and the dividend yield on the index is 1.7% per year. (Assume all the rates are continuously compounded.)
- What is the theoretical futures price for the three-month futures contract?
- What position should the fund manger take to eliminate all exposure to the market over the next two months?
- Calculate the effect of your strategy on the fund manager’s returns if the level of the market in two months is 2,000, 2,200, 2,500, 2,800, and 3,000.
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