Stock index futures contracts offer investors, portfolio managers, mutual funds etc several ways to control risk. The total risk is measured by the variance or standard deviation of its return distribution. A common measure of a stock market risk is the stock’s Beta. The Beta of stocks are available on the www.nseindia.com.
While hedging the cash position one needs to determine the number of futures contracts to be entered to reduce the risk to the minimum.
Have you ever felt that a stock was intrinsically undervalued? That the profits and the quality of the company made it worth a lot more as compared with what the market thinks?
Have you ever been a ‘stockpicker’ and carefully purchased a stock based on a sense that it was worth more than the market price?
A person who feels like this takes a long position on the cash market. When doing this, he faces two kinds of risks:
1. His understanding can be wrong, and the company is really not worth more than the market price or
2. The entire market moves against him and generates losses even though the underlying idea was correct.
Everyone has to remember that every buy position on a stock is simultaneously a buy position on Nifty. A long position is not a focused play on the valuation of a stock. It carries a long Nifty position along with it, as incidental baggage i.e. a part long position of Nifty.
Let us see how one can hedge positions using index futures:
‘X’ holds HLL worth Rs 9 lakh at Rs 290 per share on July 01, 2001. Assuming that the beta of HLL is 1.13. How much Nifty futures does ‘X’ have to sell if the index futures is ruling at 1527?
To hedge he needs to sell 9 lakh * 1.13 = Rs 1017000 lakh on the index futures i.e. 666 Nifty futures.
On July 19, 2001, the Nifty futures is at 1437 and HLL is at 275. ‘X’ closes both positions earning Rs 13,389, i.e. his position on HLL drops by Rs 46,551 and his short position on Nifty gains Rs 59,940 (666*90).
Therefore, the net gain is 59940-46551 = Rs 13,389.
Let us take another example when one has a portfolio of stocks:
Suppose you have a portfolio of Rs 10 crore. The beta of the portfolio is 1.19. The portfolio is to be hedged by using Nifty futures contracts. To find out the number of contracts in futures market to neutralise risk
If the index is at 1200 * 200 (market lot) = Rs 2,40,000
The number of contracts to be sold is:
- 1.19*10 crore = 496 contracts
2,40,000
If you sell more than 496 contracts you are overhedged and sell less than 496 contracts you are underhedged.
Thus, we have seen how one can hedge their portfolio against market risk.
