How to pre-invest future cash inflow using stock index futures?

[Nicholas]

This is part of the prompt of an FRM problem,

A portfolio manager for a large-cap growth fund knows he will be receiving a significant cash investment from a client Within the next month and wants to pre-invest the cash using stock index futures.

I don't really understand the prompt, basically, how the cash can be pre-invested using stock index future here? What is the position (long/short) and the specific steps taken for this strategy?

Also, is the portfolio manager considered as a hedger or a speculator here (obviously not arbitrager)?

 

[David Harper CFA FRM]

@Nicholas Really interesting. I agree with your inference that from a purely FRM perspective this would be an unexpected phrasing. However, although I don't have the rest of the question, it does makes sense to me (fwiw). A future contract is a agreement to buy or sell the asset (in the case the stock index) at a future time and delivery price. For example, Sep 2019 S&P 500 index contract is (right now) trading at 2595.40. We can effectively "pre-invest" cash to be received in Sep 2019 by buying (going long) this Sep 2019 contract. In a non-financial futures contract, we could use the cash received in Sep 2019 to pay for delivery. However, the stock index contract only cash settles, so when the contract matures we will (hopefully) just receive the payoff due to gain. Then we will invest the actual cash in the S&P 500 presumably, switching from synthetic (leverage via futures contract) exposure to cash exposure. The notion of pre-investing cash is consistent with a purchase (long contract) in the sense the cash funds a purchase, and the transition from long futures to ownership maintains the directional exposure. I hope that's helpful, thanks!

 

[Nicholas]

Hmm, interesting, thank you very much. Although I still think the usage of hedger is misleading.

FYI, the problem is as below,

Which of the following situations describe a hedger with exposure to basis risk?
I. A portfolio manager for a large-cap growth fund knows he will be receiving a
significant cash investment from a client within the next month and wants to
pre—invest the cash using stock index futures.
II. A farmer has a large crop of corn he is looking to sell before June 30. The
farmer uses a June futures contract to lock in his sales price.

A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.​

The answer and explanation are:

C Both of these situations describe exposure to basis risk—the risk that the difference between
the spot price and futures delivery price will change. The portfolio manager using futures to
pre-invest the cash does not know the exact date he will receive the cash and may need to sell
or hold the futures contract for a longer time period than intended. The farmer may need to
sell his June futures contract early if he sells his corn earlier than the June futures expiration
date.
​

 

[David Harper CFA FRM]

For sure, you didn't originally post the question "Which of the following situations describe a hedger with exposure to basis risk?" The logical problem with this question is that all hedgers are exposed to basis risk. To hedge is to trade (or otherwise take a position, even if naturally or organically) with the goal of reducing net risk against the underlying exposure. I like to remind folks that basis risk attaches to any hedge, and a hedge implies two positions even if one is implict. Choice (II) then gives the classic example of a short hedge. I think Choice (I) is confusing, to your original point. At a minimum, awkwardly phrased because you are led to look for the hedge to the cash receipt ...

This is flawed because the actual question statement--i.e., Which of the following situations describe a hedger with exposure to basis risk? -- is unduly forcing the reader to contemplate the possibility of a hedger who would not have basis risk, so you don't really know if you are looking for a hedger, or a hedger who does not incur basis risk. And at a minimum choice (I) is muddled in presenting the exact nature of the hedge. It's always interesting to see how some others write their questions. Thanks,