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Using index futures: A case for hedging - I

Kshama Fernandes

Futures markets provide an excellent avenue for hedging, speculation and arbitrage. In the next few weeks, we look at how these markets can be used for hedging.

Many of the participants of the futures markets are hedgers. Their aim is to use futures markets to reduce a particular risk that they face. This risk may relate to the price of oil, a foreign exchange rate, the level of the stock market or some other variable. A perfect hedge is supposed to completely eliminate risk. Perfect hedges however are rare.

As the quote goes, "Perfect hedges are only found in a Japanese garden." So the goal basically ought to be the construction of hedges which perform as close to perfect as possible. How does one go about constructing these hedges? Given the hope that index futures will start trading on the National Stock Exchange (NSE) by mid-June, we take a look at how index futures can be used for hedging.

Here we take the case of Mr Kumar who does stock analysis. He has been studying Reliance for some time and believes that the company would declare good results and that the stock price would rise. So he goes ahead and buys shares of Reliance thus taking on a long Reliance position of Rs 200,000.

Assuming that his understanding of the company is correct and that Reliance does in fact hold the promise of good results, what could go wrong for him? A fall in the market level. Even the best stockpicker faces the risk of loss due to a drop in the market. So is the case with Kumar. A few days later, the S&P CNX Nifty drops and he makes losses even though his basic understanding of Reliance was correct.

Why does this happen? This happens because every buy position on a stock is simultaneously a buy position on the index. A long Reliance position generally gains if the S&P CNX Nifty rises and generally loses if S&P CNX Nifty drops. What does this mean? It means that though Kumar purely wants to be long Reliance and has no interest whatsoever in the index, a long position on the stock effectively forces him to be long Reliance + long S&P CNX Nifty. Every long position holder is forced to be an index speculator even though he may have no interest in the index. So what should he do to remove the index exposure that he faces?

The technique is simple. Every time he takes a long position in a stock, he should sell some amount of S&P CNX Nifty futures. This will then offset the hidden index exposure that exists in every long stock position. Once this is done, he will have a position which is purely about the performance of the stock and not the index.

Hence for Kumar, the position long Reliance + short S&P CNX Nifty is a pure play on the value of Reliance, without any extra risk from fluctuations of the market index. The point here is that if one believes that one is skilled at stockpicking, then stockpicking should be what one does, without having to speculate on the index. Index futures enable a stockpicker to beautifully hedge away the index exposure that comes from being long a stock.

Now given that Kumar should sell Nifty futures, how much or how little should he sell? For this he will need to know the "beta" of the stock. (The beta of a stock gives the sensitivity of the stock to fluctuations in the index, ie the average impact of a 1 per cent move in the index upon the stock.

A stock with a beta of 1.2 moves by 1.2 per cent on average when the index moves by 1 per cent and a stock with a beta of 0.8 moves by 0.8 per cent on average when the index moves by 1 per cent. He could either compute the beta himself or use the readily available betas published by NSE. Even if the betas are not known, it is generally safe to assume the beta is 1.

Given that the beta of Reliance is 1.3, to completely remove the hidden index exposure, he should take a position of 1.3 * 200,000 on the index futures market ie Rs 260,000. If the S&P CNX Nifty is at 1300, and the market lot on the futures market is 200, each market lot is worth Rs 260,000. To sell Rs 260,000 of S&P CNX Nifty he will need to sell one market lot.

Once he does this, he will have a position of:
Long Reliance                 Rs 200000
Short S&P CNX Nifty    Rs 260000

This position will essentially be immune to fluctuations in the index. The profits/losses on this position will fully reflect price changes intrinsic to the stock, and hence only successful forecasts about the stock will benefit from this position.

So if you are a stockpicker and would like to go long in a stock that you believe is undervalued, you could easily hedge away the unnecessary risk of index movements by taking an appropriate position in the index futures market. However, it must be mentioned that hedging does not remove losses. At best it succeeds in removing unnecessary exposure and reducing risk.

The author is a faculty member at the Department of Management Studies, Goa University. She handles capital markets and derivatives.

Derivatives Center

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