Hedging Using Futures

Hedging using futures

Building a portfolio is by no means an easy task for an individual or a portfolio management service provider or a fund house. A lot of research and analysis goes into stock selection for building a portfolio. Investors put in their hard-earned money over the years in building a portfolio. Any goal-based portfolio can go for a toss if the risk is not managed properly. A gain that has taken years to build can take a huge hit in a single day or within a few days.

It is wise to hedge portfolios to mitigate if not eliminate the risk of loss. While portfolio diversification helps in risk diversification in the case of unsystematic risk, it has little or no impact on addressing systematic risk. Unsystematic risk is specific to a company or a sector.

Systematic risk on the other hand means a risk that impacts all and sundry. Systematic risks like geopolitical events, acts of God, war and strife, economic growth etc., can substantially impact portfolios. This is the part that has to be addressed through hedging. Equity stocks or portfolios are exposed to risk just like a farmer’s crop that is exposed outright in the open. Hedging helps in reducing the impact on portfolios due to short-term price corrections.

What does hedging mean?

Simply put hedging means removing risk or mitigating risk. Equity markets’ price movements are difficult to predict. Any bad news can trigger a sell-off resulting in serious price erosion. For an investor in the equity market, hedging means limiting the risk of a fall in prices. It is done by taking a counter position to an existing long position.

How to take a counter position for an equity portfolio?

To hedge, a portfolio one can use derivatives instruments like futures. The advantage of using a future is that your existing portfolio itself can be used as a margin to hedge the portfolio. Of course, some amount of cash margin would also be required. Nevertheless, you can milk your portfolio efficiently. A counter position can be taken by selling futures or buying options. We shall keep options for a later day. Let us understand how to hedge with futures. 

Perfect and imperfect hedge

Hedging of cash position can be done either with stock futures or with index futures. Individual stocks in a portfolio can be hedged with stock futures. This is known as a perfect hedge. In a perfect hedge, an equal number of contracts will be sold for the shares held in each of the companies. For example, if there are 125 shares of Bajaj Finance in the portfolio then it can be hedged by selling one future of Bajaj Finance. If the market goes down the stocks will go down but the short future will gain an equal amount and if the market goes up the short future will lose an equal amount. In short, the position is locked when the hedge is created. It will neither make money nor lose money.

There are some flip sides to a perfect hedge. If a stock doesn’t have a corresponding future traded then it may be exposed to risk. Hedging with futures in a perfect hedge apart from being expensive, can have liquidity risk and require more margin.

Imperfect hedge

A portfolio can also be hedged with index futures. This is known as a partial hedge.  Constructing a partial hedge depends on the following;

• Size of the portfolio- A size of the portfolio below the notional value of one lot of an index future cannot be hedged. For example, the notional value of one lot of Nifty future is Rs.7,87,100 (Lot size (50)X future price (15742))
  
• The portfolio should have only equities. The assets need to be equities as bonds and other instruments cannot be correlated with the index.

• Correlation of the portfolio with the index with which it will be hedged

• Taxation. Taxation matters as derivatives profits are taxed at 30 per cent.

To construct a hedge, we have to calculate the weighted average beta of a portfolio. Beta is the stock’s volatility compared to the market’s volatility. The market’s volatility has a beta of 1. The beta of the stocks can be calculated using the slope function in the excel sheet. For this, the returns of the stock and the index for the required period need to be calculated. After this, the slope function in excel can be used to arrive at the beta of the stock. Alternatively, exchanges and many websites provide the beta of nifty stocks which can also be used.

The purpose is to understand the correlation of the stock to the index. Correlation can be positive, negative or zero. The beta of the individual stocks so arrived is multiplied by the individual stock weight in the portfolio to arrive at the weighted beta. The aggregate of the weighted beta is the portfolio beta.

Given below is an example of the weighted beta of an equal-weight portfolio. The value of the portfolio is Rs.1,00,00,000. Let us calculate the hedge to be created based on the beta.

The portfolio beta is 0.86 which is less than one meaning it has a low correlation. The hedge to be created is calculated by multiplying the portfolio value with the portfolio beta i.e., Rs.1,00,00,000 X 0.86= Rs.86,00,000. The number of shares of nifty future to be shorted at the market price of Rs.15,742 will be Rs.86,00,000 divided by Rs.15,742= 546 shares of nifty future which is approximately 546/50 (lot size of nifty future) = 10.92 or 11 lots.

Conclusion

Hedging is essential for an investor as a portfolio is exposed to uncertainty and risk. Hedging, therefore, is a tool that mitigates risk and addresses and provides for uncertainty. On the flip side, it prevents the investor from making potential gains. Hedging costs and taxation keep people from not taking a hedge. However, if one compares this cost with the potential loss hedging a portfolio is unavoidable. Stay safe. Stay hedged.

Frequently Asked Questions

What is hedging?

Hedging is a tool to guard against risk. Simply put it is a measure to reduce or mitigate risk

How does one hedge his risk?

Hedging is taken by taking a counter position against your cash position or portfolio. For example, if the market is expected to fall and your portfolio is correlated with the market a counter position of short index future is created. 

What is a perfect hedge?

A perfect hedge is when the stocks in the portfolio are hedged against stock futures of an equal quantity of stocks in the portfolio.

What is an imperfect hedge?

When a portfolio is hedged with an index future it is known as a partial or imperfect hedge.