Question

I have been assigned to implement a 3-month hedge for a stock mutual fund that primarily invests in medium-sized companies. the mutual fund has a beta of 1.15 relative to the S&P Midcap 400, and the net asset value of the fund is 175 million. should you be long or short in the futures contract? assuming the index is at 1,450 and its future contract size is 500 times the index, determine the number of contracts to use in designing your cross-hedge strategy.

Answer 1

Part a)

In the given case, you are long in the asset (in the spot market). Therefore, to create headge, you will have to short the futures contract.

Answer for Part a) is Short in the futures contract.

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Part b)

The number of contracts to use in designing your cross-hedge strategy is determined as follows:

Number of Contracts = Beta of Mutual Fund Relative to the S&P Midcap 400*Net Asset Value of the Fund/Closing Value of the Fund

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Here, Beta of Mutual Fund Relative to the S&P Midcap 400 = 1.15, Net Asset Value of the Fund = $175 million or $175,000,000 and Closing Value of the Fund = 1,450*500 = $725,000

Using these values in the above formula, we get,

Number of Contracts = 1.15*(175,000,000)/725,000 = 277.59 or 278 contracts (answer for part b)