Hedging
Illustration 1: Selling stock index futures to protect the portfolio
Sometimes, you may have a view that the market will fall in the future. At
other times, you may feel that the market is going to have a few days of
massive volatility, and you do not want to bear that amount of volatility. The
union budget, and period of onset of monsoon etc. are such events. Many
investors do not want to speculate on such events. When investors have such
anxieties, stock index futures provides a convenient alternative to remove
exposure to the stock market for a short time. Investors having a portfolio
can sell the stock index futures and have an hedged position.
How to do this actually?
1. The beta of the portfolio needs to be calculated. Beta is a measure
of likely change in the value of the portfolio in relation to the change in
the stock price index. Beta of the portfolio is the weighted average(weights
in proportion to the value of holding) of betas of the shares in the
portfolio. The values of betas of individual shares are calculated by
regression of daily return on the share and daily return on the index. NSE web
site gives beta values of for the actively traded shares.
2. The value of the portfolio is multiplied by the value of beta to get
the value of the futures position to be sold.
3. Let us assume a. Portfolio value is Rs.30 lakhs. b. Beta of the
portfolio is 1.2 c. Current value of BSE Sensex(June 2001) is 3410. d. July
Sensex future is selling at 3445.
4. The position to be taken in futures is portfolio value multiplied by
beta i.e. Rs.36 lakhs (Rs.30 lakhs*1.2)
5. The number of future contracts to be sold is the position to be taken
in futures divided by the value of one futures contract. Each futures contract
will be for Rs.1,72,250 (3445*50). Hence number of contracts is
Rs.36lakhs/172250 = 20.90 contracts. Let us round it to 21 contracts.
6. What will happen if after 15 days Sensex goes down to 3000. The July
future may go down to 3030. Investor buys back the futures contract now and
thus squares off the futures position. The profit made on the futures position
would be Rs.4,35,750 ((3445-3030)*50*21).
7. The loss suffered on cash position is Rs.4,32,845
[{(3410-3000)/3410}*1.2*Rs.30 lakhs]
8. Thus the hedge in futures market compensates for the fall in spot
market prices.
Warning:
Hedging does not always make money. If the index has gone up in stead of
going down futures position will show a loss and the investor has to fund it
if required by reducing his portfolio. The best that can be achieved using
hedging is the removal of unwanted exposure. The hedged position will make
less profits than the un-hedged position, half the time.
The investor should adopt this strategy for the short periods of time where
the market volatility that he anticipates makes him uncomfortable, or when he
plans to sell his holdings in the near future.
Illustration 2: Buy stock index futures to hedge planned purchase of equity
shares in the future
A mutual fund has received large amount of funds which are to be
invested in the stock market. The fund managers need time to research stocks
and carefully pick stocks that are expected to do well. After selecting the
stocks, they cannot rush to the market and place orders to buy as it would
generate large ‘impact costs’. The execution would be improved
substantially if they could instead place limit orders and accumulate the
shares at favorable places. But all this effort takes time, and during this
time the market may go up.
Index futures offer a convenient way of acquiring exposure to the stock
market. The mutual fund can buy futures contracts for the value of the funds
to be invested immediately. As and when its buys the shares it wants it can
sell contracts equal to that amount. This hedging ensures that the fund will
buy the shares it wants close to their current prices. Any increase in the
market would be compensated by the profits it makes on the futures position.
Once again it is to be noted that if market goes down in price, the mutual
fund does not benefit. The hedge locks in the prices. Hedger does not lose if
prices go up. He does not gain if prices come down. Options provide an
opportunity to the hedger to enjoy profits if the market moves in a favorable
position and protect him if the market moves in an unfavorable position.
Illustration 3: Hedged long position in a share (Long Stock/Short Futures)
A stock picker picks a share to outperform the market due to reasons specific
to the stock. A position in that stock may not provide profit to him if the
general market goes down. Every buy position on a stock is simultaneously a
buy position on the general market. The exposure to the general market can be
removed by selling an index future. Then the position becomes a focused play
on the performance of the stock. The earliest hedge funds were involved in
similar hedging strategies only.
Example:
1. An investor wants to acquire a long position of Rs. 1million in
Tisco. The current market price of Rs.125. The beta of Tisco is 1.23 according
the NSE site.
2. Hence he requires a short position of Rs.1.23 million on the Nifty
futures market to totally remove his Nifty exposure.
3. Nifty futures with August maturity is available at 1099. Each
contract will have a value of Rs.2,19,900. 5 contracts of Nifty futures need
to be sold. (The actual value is 5.59. Rounding was done on the lower side).
4. With this hedge if Nifty goes down, investor will not suffer
as his short position in futures will earn him the profit. He will have the
benefit of relative performance of Tisco to the market.
Illustration 4. Hedged short position (Short stock/Long futures)
Stock pickers may be good in identifying shares likely to have a bad
performance in the market. Their short positions in such shares may not yield
them profits because of a rise in the general market. Stock pickers can create
hedged short positions by combining the short position in the stock with a
long position in the index future. The mechanics of this strategy are exactly
similar to the creating of a hedged long position in the stock.