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FRM Part I · FRM Exam Part I · Introduction to Derivatives

A fund manager holds a diversified equity portfolio and expects short-term market weakness but does not want to sell the securities because of transaction costs and tax. Which statement best describes the effect of shorting stock index futures against the portfolio?

Shorting index futures cuts the portfolio's market exposure without selling the stocks, saving transaction costs and tax. It does not eliminate risk entirely, because basis risk and stock-specific differences from the index remain. It is a hedge, not a riskless arbitrage.

  1. AIt removes all risk, including basis risk, from the portfolio
  2. BIt reduces market exposure while the stocks remain in the portfolio, leaving residual basis and non-market riskCorrect
  3. CIt increases the portfolio beta, magnifying losses if the market falls
  4. DIt is an arbitrage that guarantees a riskless profit above the risk-free rate

Explanation

Shorting index futures offsets market (beta) exposure without selling holdings. Residual risks remain: basis risk and the portfolio's idiosyncratic tracking difference from the index. It lowers, not raises, beta, and is hedging, not arbitrage.

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