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Harvard Business School 9-293-024
Rev. December 16, 1994
BEA Associates:
Enhanced Equity Index Funds
On the afternoon of July 13, 1992, Messrs. Jeffrey Geller and David DeRosa, derivatives
portfolio managers at BEA Associates, were considering alternative ways of investing the assets of a
new $100 million enhanced index account. They wanted to find the most attractive combination of
derivative and cash market positions to achieve the client's objective which was to outperform the
S&P 500 stock index by 50 basis points in a low risk manner. The alternatives included the use of
over-the-counter equity swaps, a relatively new financial instrument that had proliferated in recent
years.
BEA Associates
BEA Associates was an investment advisory firm founded as Basic Economic Appraisals in
1934. As of March 31, 1992, the firm managed $15.4 billion representing over 164 institutional clients.
Its separate accounts clients were principally corporate, public, and multiemployer pension funds,
and foundations and endowments. BEA also managed several mutual and commingled funds, and a
number of closed-end country funds. The firm employed 33 investment professionals—most of
whom had 10 years or more of experience—and 76 support staff.
BEA offered a variety of specialized investment management services grouped under equities
($3.4 billion), fixed income ($5.6 billion), derivative-based strategies ($5 billion), and international
equities ($1.6 billion). (See Exhibit 1). The firm boasted strong performance records in each of these
product areas. BEA also offered clients investment consulting services in the areas of hedging and
asset/liability management, pension funding and asset allocation, and transactions cost
measurement, all fields in which the firm considered itself to be an innovator and industry leader.
Derivatives Management
BEA's investment philosophy was to emphasize return enhancement as well as risk control,
the objective being to seek maximum return per unit of risk, or minimum risk per unit of return. The
firm also aimed to offer clients a high degree of product customization. In pursuit of these aims, BEA
made extensive use of derivative instruments such as options, futures, and swaps.
This case was written by Professor André F. Perold as the basis for class discussion rather than to illustrate either effective
or ineffective handling of an administrative situation.
Copyright © 1992 by the President and Fellows of Harvard College. To order copies or request permission to
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1
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293-024 BEA Associates: Enhanced Equity Index Funds
In its more traditional equity and fixed-income portfolios, where outperformance was sought
principally by investing in attractively valued stocks, bonds, and other physical securities, derivatives
were used mainly as a low-cost way of controlling market risk and currency risk. In its derivatives-
based portfolios, derivative instruments were used much more extensively both to manage desired
portfolio risk exposures and, through various arbitrage-like strategies, to generate incremental
returns. Derivatives-based products consisted primarily of enhanced equity index funds ($1.6 billion,
described more fully below) and portfolio hedging ($3.2 billion). Portfolio hedging involved overlaying
on top of an already existing portfolio a series of derivative hedge positions designed to tailor the
portfolio's exposure to broad market risks such as currency risk, interest rate risk, or equity market
risk. A typical hedge program would be aimed at limiting the portfolio's downside exposure while
retaining much of the upside exposure to the risk in question.
BEA's derivatives group was formed in 1982. Currently, the group consisted of three
portfolio managers, two traders, and two portfolio assistants. The portfolio managers were Jeffrey
Geller, Managing Director, head and founder of the group, David DeRosa, and Vincent Bailey; the
traders were Mark Barres and Mario Montoya. Each member of the group had a particular area of
specialization and a strong background in the area of derivatives.1 Investment decisions were made
by each portfolio manager individually, but only after discussion with the traders and other portfolio
managers. No "new" kinds of trades could be implemented without Jeffrey Geller's approval. The
complexity and ongoing maintenance requirements of derivative strategies made such group
consultation a critical part of quality and risk control.
Enhanced Equity Index Funds
David DeRosa explained the basis of BEA's approach to enhanced equity index fund
management:
Compare investing in an S&P 500 index fund with the synthetic alternative of
investing in money market securities and buying S&P 500 futures. In the case of the
index fund, your cash goes to purchase the stocks in the index, and your return
comes in the form of dividend income plus capital gains or losses on the stocks. You
forego interest on the cash.
In the synthetic alternative, you do not pay anything for your futures position, and
you earn capital gains or losses on the futures contract which will closely mirror the
gains or losses in the index. You forego the dividends on the stocks, but you earn
interest on the cash.
If the futures are correctly priced,2 these two strategies should produce virtually
identical results—regardless of the subsequent direction taken by the market. The
two methods will thus be economically equivalent.
The futures approach has several actual and potential advantages: First, index
futures have much lower transaction costs than stocks (roughly a 15:1 advantage),
and much lower custodial and administrative costs. Second, implicit in the futures
price is an interest rate, usually above the Treasury bill rate and slightly below LIBOR
(applicable to the term of the contract). If you can earn returns on your cash in excess
1Mr. Geller and Mr. DeRosa, for example, each had 14 years of experience investing with derivatives, and had
authored books (in the case of Mr. DeRosa) and articles on the use of derivatives. Both had graduated from the
University of Chicago Graduate School of Business, Mr. Geller with an MBA, Mr. DeRosa with a Ph.D.
2That is, according to the cost-of-carry model in which the futures price equals the price of the underlying stocks
plus the interest that can be earned on the cash minus the dividends foregone by not owning the stocks.
2
BEA Associates: Enhanced Equity Index Funds 293-024
of this "implied repo" rate, say by 40 basis points, the futures strategy will outperform
the index fund strategy by the 40 basis point spread. Third, futures contracts need to
be rolled over on or before their maturity date. This "calendar roll" can be
accomplished at a profit whenever the further out contract is attractively priced.
The principal disadvantages of the derivatives approach stem from the loss of
potential stock loan fees (quite small in the case of the S&P 500), and from the risk
that the far contract will be unfavorably priced at the time of a rollover.
To date, BEA had been highly successful in implementing the synthetic approach (see Exhibit
2), consistently earning returns in excess of the index averaging 80 basis points per annum. This
outperformance stemmed mainly from historically favorable mispricing of the futures calendar roll—
from which the firm had devised ways to profit by as much as 30 basis points per annum—and also
from various arbitrage techniques that the firm employed to obtain enhanced cash returns.
The enhanced cash strategies involved buying certain securities and selling short related
securities. BEA had done arbitrage trades involving a broad range of fixed income securities,
convertible bonds, stock index baskets, stock index options, currency options, and other derivative
instruments. The riskiness of these strategies varied from almost no risk to moderate risk, and the
returns tended to vary commensurately. Accounts were categorized by degree of risk tolerance, and
matched with enhanced cash strategies of appropriate riskiness.
Recently, the bulk of BEA's cash enhancement trades involved positions designed to take
advantage of the mean-reverting pattern in the volatility of markets. In these trades, BEA would
usually be a "buyer of cheap volatility," but occasionally a "seller of expensive volatility" after a large
informational shock to a market as in October, 1987. For example, the actual volatility of U.S. stocks
and the $/DM and $/Yen exchange rates currently appeared far higher than the volatility
assumptions implicit in the prices of options on the S&P 500, the $/DM, and the $/Yen. BEA was
considering trying to benefit from this discrepancy by purchasing "straddles" (combinations of puts
and calls) on these markets, and dynamically hedging out the exposure of the position to directional
moves in the markets. BEA was also contemplating doing the exact opposite—selling puts and calls—
in the Japanese stock market which, after its recent tumultuous plunge, appeared far less volatile than
what was implied by the prices of Japanese stock index options.
Over-the-Counter Derivatives
Gaining exposure to the S&P 500 through index futures was but one way to obtain the index
return synthetically. Over-the-counter derivative securities like index-linked swaps represented
another alternative. (The exact mechanics of some of these securities is described later in the case.)
Unlike derivatives traded on organized exchanges, over-the-counter derivatives involved bilateral
negotiations between parties (usually between dealers and their customers). Standardization of terms
was less important in this market, permitting a greater degree of customization. There was also no
central clearing house to monitor collateral and enforce the performance of counterparty obligations.
Accordingly, participation in this market required close attention to the management of counterparty
risk.
Over-the-counter derivative contracts have existed at least since the seventeenth century.3
However, the volume in over-the-counter derivatives only began to mushroom in the mid 1980s, first
3A 1688 treatise by Joseph de la Vega reveals that options and other derivative contracts were actively traded on
the Amsterdam stock exchange at that time. In Capital Ideas (The Free Press, 1992), Peter Bernstein reports that
in Book I of Politics, Aristotle tells an anecdote about Thales that makes mention of a financial option.
3
with the proliferation of interest rate swaps, caps, and floors, then foreign currency swaps and
options and, quite recently, equity-linked swaps and related securities. The notional amount of all
swap contracts outstanding in 1992 was estimated at in excess of $3 trillion.
While the interest rate swap market initially grew out the needs of debt issuers, the equity-
linked swap and related derivatives market was primarily investor-driven. Financial institutions
would write these contracts to create custom products for investors. Examples of some of the more
esoteric contracts included currency-hedged equity index swaps, which would allow the investor to
contractually receive the return on a foreign stock market hedged into dollars without the investor
having to own any foreign stocks or engage someone to perform the currency hedging; and asset
allocation swaps which, for example, could allow the investor to maintain a constant 60/40
stock/bond allocation without having to rebalance as market movements drove the existing
allocation away from its target ratio. Any of these swaps could be tailored to have additional features
such as a minimum downside risk or early termination under certain market conditions, for example,
after a market index had appreciated 20%.
Variants of these swap contracts came in the form of over-the-counter index-linked notes.
These were medium-term notes whose final redemption value floated with the return on the index of
choice (for example, the currency-hedged return on a foreign stock market; or the return on the S&P
500 with downside protection).
Index-linked notes and swaps were not always accorded the same tax treatment. For
example, until recently, swaps had not been granted safe harbor from the unrelated business income
tax (UBIT) that could be assessed on U.S. tax-exempt investors like pension funds. On the other hand,
index-linked notes were exempt from UBIT because they qualified as debt securities. Index-linked
notes had increasingly been issued to meet demand from U.S. tax-exempt investors. A long-awaited
July 1992 Internal Revenue Service ruling stating that U.S. tax-exempt institutions could not be taxed
on income earned on swap contracts was expected to give a strong boost the over-the-counter
derivatives market.
The Client
BEA's new enhanced index client was an Luxembourg subsidiary of a Japanese life insurance
company. The $100 million was part of the insurer's global equity portfolio, and was to be invested
with the goal of outperforming the S&P 500 by 50 basis points per annum without taking substantial
risk.4 he insurer had approached BEA after hearing a presentation from a Wall Street firm on index-
linked notes. The firm had offered to issue the insurer a three-year note with a 2.65% coupon paid
semiannually, and final principal equal to par value multiplied by the ratio of the S&P 500 index level
at the end of year three to the level of the S&P 500 currently. The all-in price of the note was par, here
equal to $100 million. The issuer's publicly traded medium-term notes were A-rated. The insurer
had invited a comparison of BEA's enhanced equity product with this note offering and had decided
to invest instead with BEA.
Under the terms of the investment advisory agreement, the client permitted BEA to create the
portfolio's S&P 500 exposure with the use of futures, options, swaps, or index-linked notes, and to
seek enhanced cash returns by taking offsetting positions in cash market and derivative securities.
Counterparties had to have A1/P1 commercial paper ratings and be rated A or better for longer-term
debt. Swap agreements had to conform to the standards set by the International Swap Dealers
Association (ISDA).
4Performance would be measured in U.S. dollars.
4
The client had also asked BEA to be cognizant of withholding taxes in performing its
calculations. Most countries imposed substantial withholding taxes on dividends declared by
publicly-held corporations, of which about half usually could be recovered under tax treaties, if
applicable. Ironically, investors domiciled in countries normally regarded as "tax havens," like
Luxembourg, usually were unable to recover withholding taxes. Exhibit 6 contains information on
withholding taxes for specific countries.
The Decision at Hand
In deciding how to invest the money, Mr. Geller and Mr. DeRosa first wanted to evaluate
how to best create the portfolio's exposure to the S&P 500. They started by evaluating the current
pricing of the S&P 500 index futures contracts. Trader Mark Barres had supplied them with pricing
and other information pertinent to the September and December contracts. (See Exhibit 3.) With the
S&P 500 index futures market being one of the most liquid in the world, transaction costs would be
small. Commissions were $20 per contract on a round-trip basis (about one basis point per dollar of
exposure), and the bid-ask spread for $100 million of exposure was currently .10 "S&P points" or 2.4
basis points. The position would require initial margin of $10,000 per contract (4.8%) which BEA
would post in the form of U.S. Treasury bills maturing within six months. Mr. Barres opined that the
futures contracts seemed better priced than in recent days, as did the calendar roll.
Instead of using index futures to obtain its stock market exposure, BEA could enter into an
S&P 500 index swap. In conversations with various dealers earlier in the day, the best Mr. DeRosa
could find in the required size was a three-year swap at LIBOR minus 10 basis points. That is, BEA
would make quarterly payments to the dealer of three-month LIBOR minus 10 basis points, and the
dealer would make quarterly payments to BEA of the total quarterly return on the S&P 500, both
payments based on a notional amount that would begin at $100 million and be increased or decreased
at the end of each quarter in proportion to the total return on the S&P 500. Payments would be netted
so that only the difference between the index return and LIBOR minus 10 basis points would be paid
to BEA if the difference was positive, or paid by BEA to the dealer if the difference was negative. The
dealer was a prominent A and A1/P1-rated New York investment bank.
Enhanced Cash Alternatives
Mr. Geller and Mr. DeRosa currently were considering two enhanced cash alternatives. The
first involved purchasing the basket of stocks in the Morgan Stanley Europe Australia Far East
(EAFE) index and entering into a swap agreement much like the S&P 500 swap described above,
except that BEA would pay the EAFE return on the basket and receive LIBOR plus or minus a spread.
EAFE swaps were being done fairly regularly, reflecting increased investing abroad by U.S.
institutions. Summary information on the EAFE index is provided in Exhibit 4.
During the morning, Mr. DeRosa had tried to negotiate favorable terms on a three-year swap
with a AAA-rated bank. As in the previously mentioned swap, payments would be netted and made
quarterly; the notional amount would begin at $100 million and be increased or decreased at the end
of each quarter in proportion to the total return on the EAFE index. The index return—calculated by
Morgan Stanley—assumed withholding taxes on dividends from the perspective of a Luxembourg
investor. Initially, the bank had offered to pay Mr. DeRosa three-month LIBOR minus 80 basis points
in return for receiving the total return on the EAFE index. After considerable haggling, the bank had
agreed to do it for LIBOR even. Mr. DeRosa felt he could probably do still better (perhaps by five
basis points or so) if he bided his time and waited for a special opportunity.
5
There were a variety of factors to be taken into account in analyzing this alternative. First,
BEA's traders had estimated that the round-trip transaction cost to purchase, and eventually sell, the
EAFE stocks would be about 200 basis points inclusive of all transfer taxes, commissions, and bid-ask
spreads. (See Exhibit 5 for further information on the costs of trading and holding index baskets.)
Second, he thought the client could negotiate a custody fee of 7 basis points per annum, a
little higher than the custody costs for a typical S&P 500 basket.5
Third, there would be potentially large stock loan fees that could be earned on the portfolio of
stocks. In many countries, especially Japan and Germany (which constituted a large fraction of the
EAFE index), large amounts of shares were held by institutions that, for reasons of relations with the
underlying companies or for regulatory reasons, were unwilling lenders of stock. Short sellers thus
found it difficult to borrow shares of stock and had to pay premium loan fees. How these fees were
to be divided between custodian and client had to be negotiated. The custodian's willingness to share
the fees generally depended on the account size, the portfolio turnover, and the ongoing nature of the
client relationship.
Based on previous experience, Mr. DeRosa estimated that an EAFE portfolio would, on
average, generate about 40 basis points per annum in lending fees, occasionally going as high as 1%
on an overnight basis. In contrast, lending fees that could be earned on stocks in the S&P 500 could
range as high as 30 basis points per annum on an overnight basis, averaging more like 10 basis points
per annum. Negotiations on lending fees were usually a "long and arduous affair." Mr. DeRosa
thought the client could probably get its custodian to agree to a 50/50 share of these fees.
The second enhanced-cash alternative was an inventory financing trade. BEA had been
approached by a major U.S. financial institution wanting to move part of its inventory of Japanese
stocks off balance sheet. The institution would sell BEA a $50 million portfolio of these stocks and, for
an additional $50 million, a European put option to sell the identical basket of stocks back to it in one
year at a price of $100 million plus one-year LIBOR plus 40 basis points (calculated on $100 million).
The portfolio contained about 200 names and closely resembled the portfolio comprising the Nikkei
stock average. The transaction would be directly between the institution and BEA (acting on the
client's behalf) and would involve no additional transactions costs (including savings of Japanese
stamp tax of 30 basis points), both at the outset or at the time of exercise of the put option. Mr.
DeRosa had received indications that the custody fees for this portfolio would be 10 basis points per
annum plus "ticket" costs of $40 each way, and that stock loan fees averaging 60 basis points per
annum could be earned, with the split between client and custodian again to be negotiated.
The institution in question had an A rating. However, the put option would be written by
one of its off-shore subsidiaries created expressly for the purpose of this kind of transaction. The
subsidiary had no operations other than a balance sheet of financial assets and liabilities. Having no
publicly traded debt outstanding, it was unrated. However, the subsidiary was capitalized and
managed in such a way so as to be "about AAA." BEA would be able to inspect its balance sheet and
hedging operations on a confidential basis prior to entering into the transaction.
5Custody fees usually had a fixed per annum charge plus a "per ticket" amount (i.e., per company in the
portfolio). Typical charges for an S&P 500 basket were 3 basis points per annum plus $18 per ticket, or $36 on a
round-trip basis. On $100 million, the round-trip ticket charges would amount to 500 x $36 ÷ $100 million = 1.8
basis points. Total charges would thus be around 5 basis points for a one-year holding period.
6
Exhibit 1 BEA Associates Product Line
Equity Management
U.S. Equity Management

Convertible Security Management
Futures and Options Integrated Equity
Balanced Portfolio
Global Equity Management
Portfolio Hedging
Fixed Income Management
Structured Active Bond Portfolios

Investment Grade Bond Management
Enhanced Bond Indexing
Immunization/Dedication
Intermediate Bond Management
Fixed Income Hedging
High Yield Bond Management
Cash Management
Municipal Bond Management
Derivatives Management
Portfolio Hedging
Enhanced Index Funds
Market Neutral Arbitrage
Currency Hedging
Portfolio liquidation/pension plan restructuring
Immunization/structured fixed income
Futures and options integrated asset management
International Equity Management
International equity
Global equity
Emerging markets equity
7
Exhibit 2 BEA Enhanced Equity Index Composite (Annualized returns for periods ending 3/31/92a)
Years BEA S&P 500
1 11.5% 11.1%
2 13.1% 12.7%
3 15.3% 14.8%
4 16.4% 15.6%
5 11.2% 10.4%
a Before management fees and custodial costs.
8
Exhibit 3 Miscellaneous Pricing Information on July 13, 1992
a) S&P 500 index futures contracts
Days until
Expiration Price expiration Dividendsa LIBORb
September 1992 $414.65 66 $2.43 3.49%
December 1992 $415.15 160 $5.52 3.56%
b) Level of S&P 500 index: $414.87
c) Interest rates
LIBOR
Term
(months) Rate (%)c
1 3 3/8
2 3 7/16
3 3 1/2
6 3 5/8
9 3 3/4
12 3 7/8
U.S. Treasury and Corporate Notes
Corporate spread over Treasurys (bp)
Term (years) U.S. Treasuryd AAA AA A
1 3.51 10 15 20
2 4.28 20 35 45
3 4.77 20 35 45
a Estimated dividends to be received on one unit of the S&P 500.

b Applicable LIBOR rate for the term of the contract (expressed as a 365-day bond equivalent yield).
c 360 day money-market yield.
d Bond-equivalent yield-to-maturity.
9
Exhibit 4 Morgan Stanley EAFE Indexa (June 30, 1992)
Capitalization weight as
Country a percentage of index Dividend yield (%)
Austria 0.6 1.8
Belgium 1.3 5.2
Denmark 0.8 1.8
Finland 0.3 2.1
France 7.0 3.4
Germany 7.8 3.5
Italy 2.3 3.3
Netherlands 3.4 4.3
Norway 0.5 1.9
Spain 2.5 5.1
Sweden 1.7 3.2
Switzerland 4.1 2.2
United Kingdom 21.2 5.1
Europe 53.6 4.1
Australia 3.0 3.7
Hong Kong 3.1 3.4
Japan 38.5 1.1
New Zealand 0.4 5.6
Singapore/Malaysia 1.4 1.8
Pacific 46.4 1.5
Total EAFE 100.0 2.9
a Source: Morgan Stanley & Co.
10
Exhibit 5 Estimated Costs Associated with Direct Equity Ownershipa
Stamp taxes and Dealer Portfolio

commissions Spread rebalancingb Custodyc
Australia - All-Ordinaries 1.60% 1.60% 0.32% 0.15%
France - CAC-40 0.90 1.50 0.23 0.15
Germany - DAX 0.50 1.40 0.19 0.15
UK - FTSE-100 0.90 1.20 0.21 0.15
Japan - TOPIX 0.80 0.90 0.17 0.15
Netherlands - EOE 0.75 1.50 0.23 0.15
Switzerland - SMI 0.80 1.50 0.23 0.15
U.S. - S&P 500 0.25 0.70 0.10 0.05
a Source: J.A. Allen and J.L. Showers, "Equity-Index-Linked Derivatives - An Investor's Guide," Salomon
Brothers, April, 1991.
b Assumes 10% portfolio turnover
c Estimates of annual safekeeping, dividend collection, reporting, and other miscellaneous expenses.
11
Exhibit 6 Dividend Taxationa
Company's Domicile
Shareholder's Ger- Hong Luxem- Switzer

domicile France many Kong Italy Japan bourg -land U.K U.S.
France 15 0 15 15 15 5 15 15
Germany 0 0 32.4 15 15 15 0 15
Hong Kong 25 26.9 32.4 20 15 35 0 30
Italy 15 26.9 0 15 15 15 15 15
Japan 15 15 0 15 15 15 15 15
Luxembourg 25 26.9 0 32.4 20 35 0 30
Switzerland 15 15 0 15 15 15 15 15
U.K. 15 15 0 15 15 15 15 15
U.S. 15 10 0 15 15 7.5 15 15
a Effective rate of dividend withholding tax (%) after deductions and tax credits under tax treaties. Source:
Morgan Stanley & Co.
12

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Harvard Business School 9-293-024

Rev. December 16, 1994

Enhanced Equity Index Funds

4Performance would be measured in U.S. dollars.

The Decision at Hand

Enhanced Cash Alternatives

Exhibit 1 BEA Associates Product Line

U.S. Equity Management

Fixed Income Management

Structured Active Bond Portfolios

International Equity Management

Years BEA S&P 500

a Before management fees and custodial costs.

Exhibit 3 Miscellaneous Pricing Information on July 13, 1992

a) S&P 500 index futures contracts

September 1992 $414.65 66 $2.43 3.49%

December 1992 $415.15 160 $5.52 3.56%

b) Level of S&P 500 index: $414.87

U.S. Treasury and Corporate Notes

Corporate spread over Treasurys (bp)

Term (years) U.S. Treasuryd AAA AA A

a Estimated dividends to be received on one unit of the S&P 500.

Exhibit 4 Morgan Stanley EAFE Indexa (June 30, 1992)

a Source: Morgan Stanley & Co.

Exhibit 5 Estimated Costs Associated with Direct Equity Ownershipa

Stamp taxes and Dealer Portfolio

Australia - All-Ordinaries 1.60% 1.60% 0.32% 0.15%

France - CAC-40 0.90 1.50 0.23 0.15

Germany - DAX 0.50 1.40 0.19 0.15

UK - FTSE-100 0.90 1.20 0.21 0.15

Japan - TOPIX 0.80 0.90 0.17 0.15

Netherlands - EOE 0.75 1.50 0.23 0.15

Switzerland - SMI 0.80 1.50 0.23 0.15

U.S. - S&P 500 0.25 0.70 0.10 0.05

Exhibit 6 Dividend Taxationa

Shareholder's Ger- Hong Luxem- Switzer

Hong Kong 25 26.9 32.4 20 15 35 0 30

Luxembourg 25 26.9 0 32.4 20 35 0 30

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