Hedging

We have seen how one can take a view on the market with the help of index futures. The other benefit of trading in index futures is to hedge your portfolio against the risk of trading. In order to understand how one can protect his portfolio from value erosion let us take an example.


Illustration:
Ram enters into a contract with Shyam that six months from now he will sell to Shyam 10 dresses for Rs 4000. The cost of manufacturing for Ram is only Rs 1000 and he will make a profit of Rs 3000 if the sale is completed.

Cost (Rs)	Selling price	Profit
1000	4000	3000

However, Ram fears that Shyam may not honour his contract six months from now. So he inserts a new clause in the contract that if Shyam fails to honour the contract he will have to pay a penalty of Rs 1000. And if Shyam honours the contract Ram will offer a discount of Rs 1000 as incentive.

Shyam defaults	Shyam honours
1000 (Initial Investment)	3000 (Initial profit)
1000 (penalty from Shyam)	(-1000) discount given to Shyam
- (No gain/loss)	2000 (Net gain)

As we see above if Shyam defaults Ram will get a penalty of Rs 1000 but he will recover his initial investment. If Shyam honours the contract, Ram will still make a profit of Rs 2000. Thus, Ram has hedged his risk against default and protected his initial investment.
The above example explains the concept of hedging. Let us try understanding how one can use hedging in a real life scenario.
Stocks carry two types of risk – company specific and market risk. While company risk can be minimized by diversifying your portfolio market risk cannot be diversified but has to be hedged. So how does one measure the market risk? Market risk can be known from Beta.
Beta measures the relationship between movement of the index to the movement of the stock. The beta measures the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down by 11% when the index goes down by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolio increases 11%. The idea is to make beta of your portfolio zero to nullify your losses.
Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Every portfolio has a hidden exposure to the index, which is denoted by the beta. Assuming you have a portfolio of Rs 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs 1.2 mn of S&P CNX Nifty futures.
Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1.

2.      Short sell the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings.

Therefore in the above scenario we have to short sell 1.2 * 1 million = 1.2 million worth of Nifty.
Now let us study the impact on the overall gain/loss that accrues:

	Index up 10%	Index down 10%
Gain/(Loss) in Portfolio	Rs 120,000	(Rs 120,000)
Gain/(Loss) in Futures	(Rs 120,000)	Rs 120,000
Net Effect	Nil	Nil

As we see, that portfolio is completely insulated from any losses arising out of a fall in market sentiment. But as a cost, one has to forgo any gains that arise out of improvement in the overall sentiment. Then why does one invest in equities if all the gains will be offset by losses in futures market. The idea is that everyone expects his portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would increase.
The same methodology can be applied to a single stock by deriving the beta of the scrip and taking a reverse position in the futures market.
Thus, we have seen how one can use hedging in the futures market to offset losses in the cash market