11.1 - What is hedge?

Hedging is one of the most useful and important applications of Futures. Hedging can be used to protect your trading positions in the event of adverse market movements. I will try to explain hedging using an analogy.

Imagine that you have a little bit of barren land outside your home. Instead of seeing it as barren and uncultivated, you decide to enlarge the area and plant some nice flowers. Then you nurture your little garden and water it often. You can watch it grow. Your efforts eventually pay off, and your lawn becomes lush green and flowers begin to bloom. The wrong type of attention starts to be drawn to your garden as the plants and flowers grow. Your little garden soon becomes a popular spot for stray cattle. These stray cows are merrily grazing on the grass and destroying the beautiful flowers. This makes you mad and you decide to protect your garden. You have a simple solution: you build a fence around your garden, or a wooden hedge, to stop the cows entering. This small workaround will ensure your garden is protected and allows your garden to flourish.

Let's now apply this analogy to markets.

• Imagine that you manage a portfolio of stocks by carefully analyzing each one. Slowly, you start to invest in your portfolio. This is the equivalent of the garden you plant.
• After your money has been invested in the market, you may realize that the markets could soon enter a turbulent phase. This would cause portfolio losses. This is similar to a stray cow wandering on your lawn and ruining your flower plants.
• You can create a portfolio hedge using futures to prevent market positions from losing money. This is similar to building a fence around your garden (or a wooden hedge).

I trust you found the above analogy helpful in understanding what hedging is. Hedging, as I mentioned earlier is a way to protect your market position from adverse movements. You don't have to believe that hedging is only for protecting a portfolio of stocks. Hedging can be used to protect individual stock positions with certain restrictions.

11.2 - The Hedge - But Why?

When discussing hedging, a common question is "Why hedge a position? " This is what you might see. A trader or investor has a stock he purchased at Rs.100.  He now feels that the market will decline, and his stock will follow. He has two options.

1. Don't take any action, and just let the stock fall with the hope that it will rebound eventually
2. You can sell the stock and then hope to purchase it back at a lower price later.
3. Position hedge

Let's first understand what happens when a trader decides to not hedge. Assume that the stock you have invested falls from Rs.100 down to Rs.75. As time goes by, we will assume that eventually the stock will rebound to Rs.100. The point is that if the stock moves back to its initial price, then why would one need to hedge?

You would agree that the 25% drop in price from Rs.100/– to Rs.75/– is a significant drop. The stock must move back from Rs.75/– to Rs.100/–, which is not a scale back by 25%. Instead, it has to move 33.33% to return to its original investment value. It is easier to drop the stock, but more work to get it back to its original value. Stocks don't rise as easily when there is a bull market. It is prudent to hedge positions whenever there is a significant adverse market movement.

What about the 2 and 3 options? The 2 nd option, where an investor sells the position to buy back the same at later stages, requires one to monitor the market. This is difficult to do. If the trader does not transact frequently, he may not be eligible for Long-term capital tax. Not to be forgotten, transaction fees are also charged for frequent transactions.

Hedging is a smart strategy because it virtually insulates the position and makes it indifferent to market events. It's almost like receiving a vaccination against a disease. The trader can hedge his position so that adverse market movements will not affect him.

11.3 - Risk

Before we can understand how to hedge our market positions, it is important that we understand what we are trying to hedge. As you can see, we are protecting the risk. But what type of risk?

You are exposed to risk when you purchase stock in a company. There are two types, Systematic and Unsystematic risk. These risks are present when you purchase stock or stock futures.

Stocks can fall (and result in losses for you) due to many reasons. These reasons include:

1. Revenue decline
2. Declining profit margins
3. Higher financing costs
4. High leverage
5. Management misconduct

These are all reasons that could lead to risk. However, there may be other reasons. But, if you look closely, all these risks are company-specific risk. Imagine that you have Rs.100,000. HCL Technologies Limited is the company you decide to invest your money in. HCL Technologies Limited announces that revenues have fallen a few months later. HCL stock prices will fall, which is quite obvious. This means that you will lose money on investment. This news will not affect HCL's stock price (Tech Mahindra and Mindtree), however. Tech Mahindra stock price will also drop if its management is found guilty of misconduct. These risks are unique to the company and do not affect other companies. These risks are sometimes called the " Unsystematic risk".

Diversification is possible to reduce unsystematic risk. This means that instead of investing all your money in one company, it's possible to choose diversification and invest in 2-3 other companies, preferably from different industries. Unsystematic risk can be greatly reduced when you do this. As an example, instead of purchasing HCL for its entire capital, imagine that you buy HCL at Rs.50,000/= and Karnataka Bank Limited at Rs.50,000/=. In such an instance, even though HCL stock prices decline (due to unsystematic risks), the damage is limited to half of the investment since the other half is invested with a different company. Instead of having just two stocks, you could have five stock, 10 or 20 stock portfolios. Your portfolio's diversification will be greater and your unsystematic risk will decrease the more stocks you have.

We are now faced with a crucial question: How many stocks should a portfolio have to ensure that unsystematic risk is fully diversified? Research suggests that a portfolio should contain at least 21 stocks to achieve the necessary diversification effect. Anything beyond 21 stocks could cause problems with diversification.

This graph should give you an idea of diversification - (image).

The graph shows that the unsystematic risks are greatly reduced when you diversify your portfolio and add more stocks. The graph begins to flatten after 20 stocks, indicating that the unsystematic risks are not easily diversifiable. The " Systematic risk" is the only remaining risk after diversification.

A systemic risk is a risk that affects all stocks. These are often macroeconomic risks that have a tendency to affect the entire market. Systematic risk can be summed up as:

1. De-growth of GDP
2. Interest rate tightening
3. Inflation
4. Fiscal deficit
5. Geopolitical risk

The list could go on, but you should have a good idea of what constitutes systemic risk. All stocks are affected by systematic risk. If you have 20 stocks that are well-diversified, then a decline in GDP will surely affect all 20 stocks. They will all be likely to fall. The system is subject to systematic risk and cannot be diversified. But, systematic risk can be "hedged". Hedging is different from diversification.

We diversify to reduce unsystematic risk, and we hedge to limit systematic risk.

11.4 - A single stock position can be hedged

First, we will discuss how to hedge a single stock future. It's very easy and straightforward. Its limitations will be explained, and then we will discuss how to hedge a portfolio.

Imagine that you have purchased 250 shares of Infosys for Rs. 2,284/- each share. This amounts to an investment of Rs.571,000/. You are clearly long on Infosys's spot market. You realize that the quarterly results will be announced soon after you have initiated this position. Infosys could announce some unfavorable numbers which could cause a significant drop in stock prices. You can hedge your position to avoid a loss on the spot market.

To hedge the spot position, we can simply enter a futures market counter position. The spot position is'long' so we need to enter a counter position in the futures markets.

These are the details for futures trades.

Short Futures @ 2285/ -

Lot Size = 250

Contract Value = Rs.571,250/

Both you and Infosys are long (in the spot market), but short (at different prices) in Infosys' futures price. We are 'neutral so price fluctuations are not an issue. We will explain this in a moment.

Let's imagine a variety of price points for Infosys after initiating the trade and what the overall effect will be on the positions.

It is important to remember that no matter where the price goes (whether it rises or falls), the position will not make money or lose money. It's as if the entire position has been frozen. The position becomes indifferent towards the market. This is why we say that a position that is hedged stays 'neutral to the overall market conditions. Hedging single stock positions is easy and straightforward, as I mentioned. To hedge the position, we can use the stock futures contract. To use the stock's futures position, one must have the exact same number of shares and lot size. If they differ, the P&L may fluctuate and position won't be fully hedged. This raises some important questions.

1. What happens if I hold a position in a stock but not a futures contract. If South Indian Bank doesn't have a futures agreement, does this mean that I can't hedge a spot in South Indian Bank?
2. This example assumed that the spot position value was Rs.570,000/–. But what if I have smaller positions, say Rs.50,000/- or even Rs.100,000. Can I hedge these positions?

The answer to these questions isn't really straightforward. Soon we will be able to explain how and why. We will now look at how to hedge multiple spot positions (usually in a portfolio). To do this, we need to first understand what " Beta” is about a stock.

11.5 - Understanding Beta (b)

Beta, denoted in Greek by the symbol "b", is an important concept in market finance because it can be used for many aspects of market financing. We are now at an ideal stage to introduce beta as it is also used in the hedging portfolio.

Beta is simply a measure of the sensitivity of the stock market price to changes in the market. It helps us answer these types of questions.

1. What is the likelihood of stock XYZ moving up by 2% tomorrow?
2. What is the risk of stock XYZ relative to other market indices (Nifty and Sensex?
3. What is the risk of stock XYZ versus stock ABC?

A stock's beta can have any value, greater or less than zero. The beta of market indices (Sensex, Nifty) is always +1. Let's say that beta of BPCL = +0.7. The following are implicit:

1. BPCL will rise by 0.7% for every +1.0% market increase.
   1. If the market rises by 1.5%, BPCL will likely move up by 1.05%
   2. If the market falls by 1.0%, BPCL will fall by 0.7%
2. BPCL is considered 30% less risky than the markets because its beta is lower than that of the market (0.7% versus 1.0%).
   1. You could even say that BPCL carries a lower level of systematic risk
3. If HPCL's beta is 0.85% then BPCL would be considered less volatile than HPCL and therefore less risky

This table will give you an idea of how to interpret stock beta values.

Here is the Beta value of a few blue-chip stocks as of January 2015.

11.6 - MS Excel Calculating Beta

Excel allows you to quickly calculate the beta value for any stock by using a function called "=SLOPE". This is how you calculate it step-by-step. I've used TCS as an example.

1. 1. Get the latest 6 month daily close prices for Nifty and TCS. This information is available on the NSE website
   2. Calculate the daily returns of TCS and Nifty.
      1. Daily return = [Today Closing price divided by Previous day closing price] -1
   3. Enter the slope function in a blank cell
      1. Format for the slope function is =SLOPE(known_y's,known_x's), where known_y's is the array of daily return of TCS, and known_x's is the array of daily returns of Nifty.
   4. TCS 6 Month Beta (3 rd September 2014 to rd February 2015) works out at 0.62

11.7 - Portfolio Hedging

We will now return to the topic of hedging stocks portfolios using Nifty futures. But before we get started, you might be wondering why Nifty Futures are used to hedge a portfolio. Why not use something else?

Remember that there are two types of risk: systematic and unsystematic. A diversified portfolio naturally minimizes unsystematic risk. The systematic risk is what is left. We know that systematic risk refers to the risk associated markets. Therefore, the best way for market protection is to use an index that represents the market. The Nifty futures are a natural option to hedge against systematic risk.

Let's say I have Rs. 800,000/- invested in the following stocks:

Step 1 - Portfolio Beta

Hedging a stock portfolio involves a few steps. First, we must calculate the "Portfolio beta" .

1. 1. • Portfolio beta is the sum "weighted beta" of all stocks.
      • The weighted beta is calculated when the stock beta and its portfolio weightage are multiplied.
      • The portfolio's weight is determined by multiplying the amount invested in each stock by its total value.
      • Axis Bank's weightage is, for example, 125,000/800,000. = 15.6%
        • The portfolio's weighted beta would then be 15.6% * 1.41 = 0.21

Below is a table that calculates the beta weighted for each stock in your portfolio.

The Portfolio beta is the sum of the weighted beta. The beta is 1.223 for the portfolio above. The portfolio is expected to rise by 1.223% if Nifty moves up by 1%. The portfolio will also be affected if Nifty falls by 1.223%.

Step 2: Calculate the hedge amount

Hedge value simply refers to the Portfolio Beta and total portfolio investment.

= 1.223 * 800,000.

= 978.400/-

This is a long-only portfolio. We have bought these stocks in the spot markets. We are aware that to hedge, we must take a position in the futures market. To hedge a portfolio worth Rs.800,000.00, we would need to short futures worth Rs.978.400/-. The portfolio is high beta and this should make it easy to understand.

Step 3: Calculate the required number of lots

Nifty futures are currently trading at 9025. With the current lot size being 25 lots, the contract value per lot is -.

= 9025 * 25

= Rs.225.625/-

Therefore, the required number of lots to shorten Nifty Futures would be

= Hedge Value/Contract Value

= 978,400/ 225625

= 4.33

This calculation suggests that to hedge a portfolio worth Rs.800,000.00 with a beta value of 1.223, one must short 4.33 lots Nifty futures. We cannot shorten 4.33 lots. However, we can short 4 or 5 lots. Fractional lot sizes are not possible.

We would be slightly under-heated if we chose to shorten 4 lots. The same applies to 5 units. We would be more hedged. This is why we can't always hedge a portfolio perfectly.

Let's say that Nifty falls by 500 points after the hedge is in place. This would be approximately 5.5%. This will allow us to calculate the effectiveness and cost-effectiveness of the portfolio hedge. For illustration purposes, we will assume that we can shorten 4.33 lots.

Nifty position

Short initiated at -9025

500 Points of decline in value

Nifty value – 8525

Number of lots - 4.33

P & L = 4.33 *25 * 500 = Rs.54.125

The short position has earned Rs.54,125/. We will investigate what might have happened to the portfolio.

Portfolio Position

Portfolio Value = Rs.800,000/-

Portfolio Beta = 1.223

Market decline = 5.5%

Expected Decline in Portfolio = 5.5% * 1.233 = 6.78%

= 6.78% * 800000

= Rs. 54,240

As you can see, the short Nifty position has gained Rs.54125 while the long portfolio has lost approximately Rs.542,240. The net market position is unchanged, with no gain or loss (please ignore the small difference). The portfolio loss is offset by the gains in Nifty futures.

I hope this helps you to better understand how you can hedge your stocks portfolio. You should replace the 4.33 lots with either 4 or 5 lots, and do the same exercise.

Let's close this chapter by revisiting two questions we raised when we talked about hedging single stock positions. For your convenience, I will also repost it here.

1. What happens if I hold a stock position that doesn't have a futures agreement? If South Indian Bank doesn't have a futures agreement, does this mean that I can't hedge a spot in South Indian Bank?
2. In the example, the spot position value was Rs.570,000/– but what if I have smaller positions, say Rs.50,000/- or even Rs.100,000. Can I hedge these positions?

You can hedge stocks even if you don't have stock futures. As an example, let's say you have Rs.500,000/– worth of South Indian Bank. To identify the hedge value, multiply the stock's beta with its investment value. The hedge value is calculated if the stock has a beta 0.75.

500000*0.75

= 375,000/­

This will allow you to hedge your spot position by simply dividing the hedge value and the Nifty's contract price.

The 2 nd question is not answered. You cannot hedge small positions with a value that is significantly lower than Nifty's contract value. Options can be used to hedge these positions. When we discuss options, we will also talk about the same.

To Summarize

1. 1. Hedging can help you protect your market position from any negative movements in the market
   2. You can offset your loss in spot market by futures market gains.
   3. There are two types risk: systematic and unsystematic.
   4. Systematic risk refers to risk that is specific to macroeconomic events. You can hedge systematic risk. All stocks have systematic risk
   5. Unsystematic risk refers to the risks associated with the company. Each company is different. It is impossible to hedge unsystematic risk, but it can be diversified
   6. Research shows that diversification is impossible beyond 21 stocks with unsystematic risk
   7. You can hedge one stock position in spot by simply taking a futures position to counter it. However, the amount of spot and futures values must be equal
   8. Market beta is always +1.0
   9. Beta is a measure of the stock's sensitivity
      1. Low beta stock is defined as stock with a beta less than 1.
      2. Stocks that have a beta greater than 1 are considered high beta stocks
   10. The 'Slope function in MS Excel allows one to easily calculate the stock beta.
   11. These steps are necessary to hedge your stock portfolio.
       1. Calculate each stock beta
       2. Calculate the individual weightage for each stock in your portfolio
       3. Calculate the beta weighted for each stock
       4. Add the beta weighted to get the portfolio beta
       5. To get hedge value, multiply the Portfolio beta by the Portfolio value.
       6. Divide the hedge value with Nifty Contract Val to find the number of lots
       7. The futures market has a shortage of the required amount of lots
   12. A perfect hedge is not easy to build, so we must either under- or over-hedge.