An important question that the investors face is how to protect their portfolio in times of volatility. One way is getting out of the cash markets (stock market) for now and entering again when market stabilizes. But this strategy may lead to a lot of uncertainty about the price that the investors will have to pay to enter again. To hedge this uncertainty and lock in the futures price the investor can make use of the derivatives products. In this article we will be talking mainly about how to hedge a portfolio by using futures and forward contracts (as both are almost similar in nature).
To learn this strategy one must know a very important concept of beta (β).
Beta is the relative movement of the stock with respect to market. Suppose Nifty moves 1 point up the stock of the company with a beta of 1.2 will move 1.2 points up. Beta is actually the systematic risk measure of the company. Actual in depth discussion will be done in subsequent articles.
β = covariance (stock index, stock)/variance of the stock
This may sound too mathematical for the common investor so in simple words to find the β of a stock an investor can Google to find the β of a stock or use a simple excel tool to find out the same. What the investor would need is the historical weekly closing price of the stock for two years and the weekly closing price of NIFTY for two years. Our website want2rich.com will soon have the same. After you have the data, put the data of the stock in column A and data of NIFTY in column B. Use the function =slope(range of stock, range of NIFTY). The value is the β of the stock. To calculate the β of the whole portfolio use the following formula
Beta of the portfolio = weighted average of betas of individual stocks=∑ βi*wi
Where wi= market value of investment in stock i/ market value of the whole portfolio.
The strategy
Suppose a manager has a portfolio consisting of three securities of Rs20 lakh, with a beta value of 1.17. The investor speculating turmoil in near future wants to reduce the beta of the portfolio to:
· 0 or no matter how the markets move investor will not incur a loss.
(a) To decrease the portfolio beta from 1.17 to 0, the portfolio manager may sell off a portion of equities and use the proceeds to buy risk free securities.
If we designate the existing portfolio as asset 1 and the risk free security as asset 2, we have,
βp =w1β1 + w2β2= w1β1 + (1-w1) β2
(Since the new portfolio consists of only two assets), we have βp = 0, β1 = 1.17, and β2 = 0(this being a risk free asset).
Substituting the known values, we get
0 = w1 x1.17 + (1- w1)0
Or, w1 = 0
Or the investor will have to sell of the whole portfolio and invest in risk free securities like govt. bonds.
(b) Alternatively, the manager can sell stock index futures contracts. Rupee value of the spot position to be hedged = 20 lakh .The amount of future contract of NIFTY to be sold= 1.17 x 20 lakh =Rs 23.4 lakh.
This way whatever will be the loss in the cash portfolio it will be offset by the forward/ future contract. Let us see how
Suppose the market (NIFTY) dips by 10%. The loss in the cash market portfolio will be equal to 20lakh*10%*1.17(β)= 2.34 lakhs. By shorting the NIFTY contracts the profit investor will make here = 23.4 lakh * 10%= 2.34 lakhs. Total loss = 2.34 lakhs- 2.34 lakhs=0.
Thus we can clearly see that by using derivatives instrument you can hedge your portfolio without exiting the cash market. The investor can also reduce the β of the portfolio if he does not want to completely hedge his position. Let us extend our previous example and now suppose the investor wants to reduce the β of the portfolio to .9 from an initial 1.17.
• (a) To decrease the portfolio beta from 1.17 to 0.9, the portfolio manager may sell off a portion of equities and use the proceeds to buy risk free securities. Using the same formula βp =w1β1 + w2β2= w1β1 + (1-w1) β2
We have βp = 0.9, β1 = 1.17, and β2 = 0(this being a risk free asset). Substituting the known values, we get 0.9 = w1 x1.17 + (1- w1) 0 , Or, w1 = 0.76923 or the investor will have to sell of (1-.76923)*20 lakh= Rs4.6154 lakh of equities and invest in govt. bonds.
(b) OR rupee value of the spot position to be hedged = Rs4.6154 lakh (1-.76923)*20 lakh.The amount of future contract to be sold= 1.17 x Rs4.6154 lakh =Rs 5.4 lakh. Investor has sold future for Rs5.4 lakh .If future price reduce by 10% because of general decline of market of 10%, he will earn from future selling = Rs 5,40,000x.1 = Rs 54,000. Now, since they are holding the same portfolio having β=1.17, portfolio value will reduce by 11.7% for a 10% decline of market price.Thus portfolio reduces by Rs20 lakh x(.117)=Rs2,34,000. Less: Earning from future selling = 54,000. Total loss = Rs1,80,000 (loss of 9% when market falls by 10%) or a β of 0.9. Shubham Goel
IIM Rohtak
