Financial Management of Risks 439Synthetic Cash
A company’s pension fund is invested primarily in the stocks of the Standard &
Poor ’s 500. The pension fund manager worries that there may be a downturn
in the stock market sometime over the next six months. She considers selling
all of the stock and investing the funds in Treasury bills. An alternate hedge
strategy that will save considerable transaction costs would be to short S&P
500 futures contracts. By establishing a short futures position, she locks in the
price at which the stocks will be sold six months hence. The fund is now insu-
lated from any f luctuations in stock prices. Since the fund is now essentially
risk free, it will earn the risk-free interest rate. Selling futures while holding
the underlying spot instrument is a strategy known as “synthetic cash.” The
strategy essentially turns stock into cash. The fund performs as if it were in-
vested in Treasury bills.
Synthetic Stock
A company’s pension fund is invested primarily in Treasury bills. The stock
market has been rising rapidly in recent weeks, and the pension fund manager
wishes to participate in the boom. One strategy would be to sell the T-bills and
invest the proceeds in equities. A more economical strategy would be to leave
the value parked in T-bills, and gain exposure to the stock market by going long
in stock futures. When the market rises, the futures will pay off. Should the
market fall, the fund will suffer losses. The fund will thus behave as if it were
invested in stocks. Ergo the name, “synthetic stock.”
Market Timing
A manager wishes to be exposed to the stock market when he anticipates a
market rise, and be out of stocks and into T-bills when he anticipates a drop.
Buying and selling stocks to achieve this purpose is very expensive in terms of
commissions. But entering and exiting the market via futures is very cheap.
The manager should keep all his funds invested in T-bills. When he feels the
market will rise, he should go long in stock index futures, such as S&P 500 fu-
tures. When he feels the market will drop, he should sell those futures, un-
winding the position. If alternatively he wished to assemble a diversified
portfolio such as the S&P 500 the old fashion way—a portfolio consisting of
actual stocks and no derivatives—he would have to buy each of the 500 stock
issues while selling his Treasury bills. This positioning would involve 501 sepa-
rate transactions. Turning the actual stock portfolio back into T-bills would
similarly require 501 transactions. Turning T-bills effectively into stocks via
long futures contracts, on the other hand, involves just one futures trade. Un-
winding the futures position would also be just one single trade. Market timing
is much more economically executed with futures contracts than with actual
equity trades.