Question;One of your most sophisticated investors, Joseph;DeLuca, believes that the stock market;will decline and hence reduce the value of his substantial portfolio. However;he does not want to sell the stocks, because the sales would generate a substantial;federal capital gains tax 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 long position in stocks, you realize that;he needs a short 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 futures contract 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 hedge $1,000,000?;Why should DeLuca sell rather than purchase the contracts?;3. How many cash will DeLuca have to put up to meet the;margin requirement? If the annual interest rate on money market 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?
Paper#50178 | Written in 18-Jul-2015Price : $32