My First Investopedia.com Article!

Discussion in 'Educational Resources' started by WallStGolfer31, Dec 4, 2006.

  1. WallStGolfer31

    WallStGolfer31 Guest

  2. Congratulations, way to go!
     
  3. ttosifa

    ttosifa

    Just read your article. A couple of points you might want to consider.

    First, a 15% increase in the S&P does not obviously produce a 15% gain on the corresponding futures. The futures contract has carry cost, which will reduce the gain on futures. In fact, if one uses a one-year time horizon on the stock purchase and a one-year futures contract, the carry cost will make the returns of both portfolios equal. Otherwise there would be an arbitrage!

    Second, investing in the S&P stocks will produces dividends, which will not be gotten by using futures as a proxy.
     
  4. WallStGolfer31

    WallStGolfer31 Guest


    A 15% increase in the S&P futures will produce a return of 15% on the underlying amount, which in the article, is $300,000 (not on the position itself, the margin used). Cost of carry is not included, I only had about 1200 words to do this, and getting into that would put me well over. This is just a simplified overview, not a textbook. :)
     
  5. ttosifa

    ttosifa

    The problem is the entire point of the article -- that one can earn "alpha" by substituting futures for stocks and earning interest on the difference in the amount invested -- crucially depends on the absence of carry cost. Any "alpha" in the strategy you suggest would be eaten up by the carry cost (and would actually be negative if one earns no interest on the $60000 margin).
     
  6. WallStGolfer31

    WallStGolfer31 Guest


    The cost of carry premium right now is only about 50 points over cash value for a Dec 07' contract. A 15% gain of the cash value is about 210 points. That does not equal the cost of carry, it's well over it.
     
  7. WallStGolfer31

    WallStGolfer31 Guest

    and that's still a 12.83% gain on the portfolio vs a 11.5% in the cash portfolio.
     
  8. ttosifa

    ttosifa

    Today's fair value premium depends on today's interest rates and today's dividend yield. Your hypothetical example uses a T-bill rate of 10% to compute the return. The fair value premium would be different if interest rates were really 10%. You are comparing apples and oranges.

    The economics are really very simple: Aside from transactions costs, liquidity issues, and tangential issues of marking to market, the strategies must provide the same return. The stock investor pays cash and receives dividends. The futures investor does neither (ignoring margins). The fair value premium represents this difference, and will reduce the returns to the futures investor to equate the returns of the two strategies.

    There is no free lunch. If there were truly any alpha in the futures strategy, no smart person would buy stocks, preferring instead the futures. And there are a lot of smart index mutual fund companies out there who do buy a lot of stock.
     
  9. Leverage aside returns of futures investor equal to returns of cash investor including dividends. With the leverage returns of futures investor equal to returns of cash investor including dividends minus the interest on cash amount held in T-bills.
     
  10. ttosifa

    ttosifa

    The example/article is about leverage. You can use the leverage to replace cash invested in stocks with cash invested in T-bills at no added risk. But if there is no added risk, there is no added return.
     
    #10     Dec 4, 2006