NASAA Series 66 Uniform Combined State Law ExaminationInvestment Vehicle CharacteristicsHard
A hedge fund manager is seeking to hedge against a potential downturn in the broader market while maintaining exposure to specific growth stocks. They want an investment vehicle that allows for leveraged short positions on an index. Which derivative strategy would be most appropriate?
- ABuying put options on individual growth stocks.
- BSelling call options on the S&P 500 index.
- CBuying an inverse exchange-traded fund (ETF) tracking the S&P 500.
- DSelling short S&P 500 index futures contracts.
Show answer & explanationAnswer & explanation
Correct answer: D. Selling short S&P 500 index futures contracts.
Selling short S&P 500 index futures contracts allows the hedge fund manager to take a leveraged short position on the broader market. As the index falls, the value of the short futures position increases, providing a hedge. This strategy offers significant leverage and direct exposure to the index's movement, making it suitable for hedging broad market downturns.
Why the other options are wrong
- A. Buying put options on individual stocks hedges specific stock risk, not the broader market, and is less leveraged than futures.
- B. Selling call options generates income but hedges only against a modest decline, and carries unlimited risk if the market rises significantly.
- C. An inverse ETF provides inverse exposure to an index but typically without the same level of leverage as futures contracts and may suffer from tracking error over longer periods.
Index Futures Contracts
A standardized, exchange-traded derivative contract that obligates two parties to exchange cash based on the difference between the contract price and the index value at settlement. Used for hedging or speculation on broad market movements.
- Highly leveraged instruments, requiring margin.
- Cash-settled, no physical delivery of index components.
- Often used by institutional investors for hedging or directional bets.
Memory trick: When the market falls, futures can be your shield.