FORWARD CONTRACTS ON STOCK PORTFOLIOS
Because modem portfolio theory and good common sense dictate that investors should hold diversified portfolios, it is reasonable to assume that forward contracts on specific stock portfolios would be useful. Suppose a pension fund manager knows that in three months he will need to sell about $20 million of stock to make payments to retirees. The manager has analyzed the portfolio and determined the precise identities of the stocks he wants to sell and the number of shares of each that he would like to sell. Thus the manager has designated a specific subportfolio to be sold. The problem is that the prices of these stocks in three months are uncertain. The manager can, however, lock in the sale prices by entering into a forward contract to sell the portfolio. This can be done one of two ways. The manager can enter into a forward contract on each stock that he wants to sell.
Alternatively, he can enter into a forward contract on the overall portfolio. The first way would be more costly, as each contract would incur administrative costs, whereas the second way would incur only one set of costs. Assume that the manager chooses the second method. He provides a list of the stocks and number of shares of each he wishes to sell to the dealer and obtains a quote. The dealer gives him a quote of $20,200,000. So, in three months, the manager will sell the stock to the dealer and receive $20,200,000. The transaction can be structured to call for either actual delivery or cash settlement, but in either case, the client will effectively receive $20,200,000 for the stock.’
Tags: STOCK PORTFOLIOS