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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 invested 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 futures. When he feels the market will drop,
he should sell those futures, unwinding the position. If, alternatively, he wished to assemble a
diversified portfolio such as the S&P 500 the old-fashioned 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 separate 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, however, involves just one futures trade. Unwinding the futures
position would also be just a single trade. Market timing is much more economically executed with
futures contracts than with actual equity trades.
A Cross-Hedge
A manufacturer of plastic water pistols wishes to hedge against increases in raw plastic pellet prices.
Unfortunately, there are no futures contracts covering plastics prices. There is, however, a contract on
oil prices, and the price of plastic is highly correlated with the price of oil. By going long in an oil
contract, the manufacturer will be paid money when oil prices rise, which is also likely to be when
plastics prices rise. Hedging an exposure with a contract tied to a correlated underlying instrument is
called a cross-hedge.
A Common Pitfall