The board of directors of Abco Company is concerned about the downside risk of a $100 million equity portfolio in its pension plan. The board’s consultant has proposed temporarily (for 1 month) hedging the portfolio with either futures or options. Referring to the following table, the consultant states:
a. “The $100 million equity portfolio can be fully protected on the downside by selling (shorting) 4,000 futures contracts.”
b. “The cost of this protection is that the portfolio’s expected rate of return will be zero percent.”
Market, Portfolio, and Contract Data
Equity index level .............. 99.00
Equity futures price .............. 100.00
Futures contract multiplier .......... $250
Portfolio beta ................ 1.20
Contract expiration (months) .......... 3
Critique the accuracy of each of the consultant’s two statements.