Books
Banking
Cards
Columnists
General
Insurance
Interview
Lifestyle
Loans
Mutual Funds
NRI
Real Estate
Stocks
Taxation
Travel

Using index futures: A case for hedging - III

Kshama Fernandes

After a lot of persuasion, my father finally decided to invest a part of his retirement proceeds into the equity market. Although he was sold on the idea of "equity premium" for the long-run (about 10-15 years in his case), with part of his life time earnings put into equities, he had lost his sleep. He would religiously follow the prices of scrips he had invested into and his moods would tell us how his portfolio was faring each day. Along with the market he'd go through upswings and downswings.

As the Union Budget season approached, he began getting more and more uneasy. "Isn't there some way I can insulate my portfolio from budgetary swings?" he asked me. At that point of time, the only way to do so would be to sell and buy back a month or so later. Doubtlessly, one would take a big hit on the transactions costs incurred on the round-trip.

But that is history. Today if you're uneasy about the market movements and would like to exit it for a short while till you became comfortable with it again, you have a choice. You would be in the same boat if you were planning to sell your shares in the near future to invest into a house or finance your child's education abroad. This planning could go drastically wrong if the market dropped by the time you actually sold your shares.

To avoid this uncertainty, all you would need to do is hedge your portfolio against market movements using index futures. Here is how one could go about doing this.

As we know, every buy position on a stock is a buy position on the index, and similarly every portfolio contains a hidden index exposure, irrespective of whether the portfolio is composed of index stocks or not. Most of the portfolio risk is accounted for by index fluctuations. Hence when one is Long Portfolio, one is invariable Long Index. To remove this index exposure all one needs to do is short the index. A position of Long Portfolio plus Short Index is typically one-tenth as risky as a position that is purely Long Portfolio.

Let us consider an example. Suppose I own a portfolio of Rs 3 million which has a beta of 0.9. How would I hedge this portfolio? By selling Rs 2.7 million of index futures.

The portfolio beta is computed as the weighted average of the stock betas. Suppose the above portfolio is composed of Rs 1 million in ITC, which has a beta of 1.2 and Rs 2 million in Hindustan lever, which has a beta of 0.8, the portfolio beta in this case is equal to ( 1*1.2 + 2*0.8)/3 or approximately 0.9. Now to obtain a complete hedge which would remove the hidden index exposure, I would have to take a short position of portfolio value times portfolio beta which as we mentioned is approximately Rs 2.7 million.

So if the Nifty is at 1500 and the market lot on NSE's futures market is 200, each market lot of Nifty would cost 3,00,000. Hence I would have to sell 9 market lots to obtain a position:

Long Portfolio: Rs 3,000,000
Short S&P CNX Nifty: Rs 2,700,000

This position will essentially be immune to any fluctuation of the index. If the index goes up, the portfolio gains and the futures lose. If the index goes down, the portfolio loses but the futures gain. In either case, the investor is hedged against market fluctuations.

When should investors adopt this strategy? For one, like I mentioned, in a case where one anticipates market volatility and simply has no appetite for it. And second, when one plans to sell one's portfolio in the near future and faces uncertainty about the final price obtained in case of sudden drop in the index. But what if my hedging horizon is two or three years? Obviously in this case, it makes more sense to sell off the shares and buy them back later. The above-mentioned strategy is an ideal way to hedge for shorter time periods.

As we are aware, hedging does not remove losses or always make money. The best that can be achieved is a reduction/removal of unwanted exposure. Having said this, there is an important decision that must be made by the investor - that of the degree of hedging. Complete hedging eliminates all risk of gain or loss. Depending upon his/her risk-taking ability, an investor may be able to tolerate some risk of loss in order to be able to hold on to some risk of gain.

In such cases, partial hedging would be the best approach to take. In the case of the example above, a complete hedge would require selling Rs 2.7 million of index futures, but an investor may instead choose to sell only Rs 2 million, in the process hoping to make some profit on the unhedged component of the portfolio. The degree of hedging would depend upon an individual's appetite for risk.

From a portfolio manager's point of view, the use of index futures market is an ideal technique to alter the portfolio beta. Typically, a portfolio manager who anticipates a bull market would want to increase the beta of her portfolio to take advantage of the expected rise in stock prices. Similarly, if she anticipates a bear market, she may go defensive and reduce the portfolio beta.

As mentioned earlier, portfolio beta is the weighted average of stock betas. In the absence of index futures contracts, changing the beta would involve selling some stocks and buying others. For instance, to reduce the beta, she may have to sell high beta stocks and invest the proceeds in buying low beta stocks. Given the high transactions cost in the equity market, this can be an expensive affair. With index futures, the portfolio manager now has an alternative.

If we accept that a well-diversified portfolio (about 20 stocks) has near zero unsystematic risk, then combining such a portfolio with a risk-minimizing short position in stock index futures creates a portfolio with zero systematic risk. Now instead of eliminating all systematic risk by hedging, it is possible to hedge only a portion of the systematic risk to reduce, but not eliminate the systematic risk inherent in a portfolio.

To do this the portfolio manager will have to sell some futures, but fewer than the risk-minimizing amount. In the example used above, instead of selling nine Nifty futures contract which is the exact risk-minimizing number of contracts, if I sold only five contracts, the new stock/futures portfolio would then have about half the systematic risk as that of the pure stock portfolio.

Similarly a portfolio manager can use stock index futures to increase the systematic risk of a portfolio by buying, instead of selling index futures. To illustrate this, assume that instead of selling nine nifty futures contracts, if I bought 18 Nifty futures contracts, the resulting stock/futures portfolio would have twice the systematic risk as the pure stock portfolio. Used appropriately, stock index futures offer a hassle-free, inexpensive technique of changing the risk of a portfolio.

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

Derivatives Center

Tell us what you think of this feature