Discrepancy (I think?) between two equitizing questions position, following, concerning, why, first

jcole21

In the first question (no need to read the whole question), the answer is A, which means that choice C is correct (i.e. "In a long-short, market neutral strategy the benchmark should be the risk-free rate" is a true statement). Given that, I would expect the answer to the second question to be C, since you have a market neutral strategy + a futures position. Can someone explain why the risk free rate is ignored in the second question? Thanks.


Question 1
Which of the following concerning investment strategies is least accurate?

A) If a manager does not have an opinion about an index stock in stock-based enhanced indexing strategy, they will not hold the stock.
B) Stock-based enhanced indexing strategy can produce higher information ratios because investors can apply their knowledge to a large number of securities.
C) In a long-short, market neutral strategy the benchmark should be the risk-free rate.

The correct answer was A.

If a manager does not have an opinion about an index stock in a stock-based enhanced indexing strategy, they will hold the stock at the same level as the benchmark. Stock-based enhanced indexing strategies can produce higher information ratios because the investor can systematically apply his knowledge to a large number of securities, each of which would require independent decisions. Because a long-short, market neutral strategy has no systematic risk, its benchmark should be the risk-free rate (the return on T-bills).



Question 2
Which of the following is the correct benchmark for a market neutral long-short strategy equitized with S&P 500 futures contracts?

A) The S&P 500 index.
B) The risk-free rate.
C) The S&P 500 index plus the risk-free rate.

The correct answer was A.

If a long-short, market neutral strategy is equitized, the benchmark is the underlying index of the futures contract (in this case the S&P 500).

lcai

You have equitized the cash( generated by the short side ) by investing in S&P 500 index futures. So your return will come from S&P 500 index not from cash.

Remember the futures price has a risk free rate "built into it" plus tracks the cash index. So the index already incorporates the risk free rate when traded as a futures contract. That is the inherent leverage available thru the Futures contract.

Plus it has the cash index equity rate of return built into it.

If you include the S&P index and the risk - free rate both , you'd be double counting the risk free rate.

In the first q, the risk free rate is all you get , since you did not equitize cash.

ll11

yes , that's right. You gain the S&P index return and give up the risk free rate of return by equitizing cash

Chuckrox

You do not need cash to go long the S&P Futures contrct , or at least very little of it. You just need margin which is frequently ignored in the calculations. So there is not much borrowing going on if you use Futures . While there is full borrowing if you invest in stocks in the index.

The futures price however builds in the risk free rate as well . So it is higher than the spot price , i.e. F=S*(1+r)^t holds under no-arb, no storage, no convenience condition.

At convergence i.e. expiry , the Futures price=Spot price.

So the implied rate of return on the futures contract is lower than the direct return on the stock index , given all the above conditions.

implied Futures return + Risk Free rate = cash index return.

or implied Futures return = cash index return - Risk free rate .

Hence the statement that you gain the cash index return and give up the return on cash i.e. the risk freee rate.



Edited 1 time(s). Last edit at Sunday, April 24, 2011 at 07:04PM by janakisri.