Client:

Pension plan

Challenge:

Avoid Cash Drag by using Cash Equitization

Solution:

Equity Index futures can be used to keep a portfolio fully exposed to its benchmark index while allowing cash to remain for operational purposes.

Overview

Cash is a necessary component of most investment portfolios. It’s present in a portfolio for operational reasons, including managing subscription/redemption flows and income streams such as dividends. Non-invested cash can perform an economic drag on a portfolio. This drag can reduce performance to benchmarks and peers.

Scenario

A pension plan or a money manager can combat cash drag by using a technique called cash equitization, which makes putting excess cash to work much easier. One primary tool for implementing a cash equitization strategy might be stock index futures contracts. Their exceptional liquidity, low transaction costs, and nearly 24-hour availability can make them an excellent vehicle for equitizing cash.                                                                                                                                  

Example

Assume a manager of a $1 billion fund has 0.50% withheld for cash purposes and E-mini S&P 500 Index futures are trading at 4536.00.  The margin on E-minis is roughly $13,000 per contract.*

The Hedge Ratio (HR) calculation = value at risk ÷ notional value of contract

In this example:

HR = $5,000,000 (0.50% of $1 billion) ÷ (4536.00 x $50)

HR = 5,000,000 ÷ 226,800

HR = 22.04 or 22 futures

Assuming the CME Group margin requirement is currently $13,000 per contract*, the initial margin required is $286,000.  (22 x $13,000).  That leaves roughly $4,714,000 ($5,000,000 -$286,000) in cash for operational purposes.

The Fund is now 100% invested in index (99.5 in securities, 0.50 futures).

Notes

* Margins are subject to change.  Please consult your FCM or CME Clearing for current levels.

Conclusion

Equity Index futures, from CME Group, can be used to keep a portfolio fully exposed to its benchmark index while allowing cash to remain for operational purposes.

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