Hedging Portfolio with Short Index Futures

An investor with a portfolio of shares may have a view that stock prices will fall in the near future. Every portfolio contains a hidden index exposure. Hence the investor may hedge his portfolio by selling index futures. This strategy makes sense for short periods of time when he anticipates a short term market volatility. Hedging strategy is designed to reduce budget related volatility. Market volatility increases one week before and two weeks after a budget. Hence, many investors can avoid these fluctuations by hedging their portfolio with short index futures.

Consider an investor who has a portfolio consisting of five shares and the total portfolio value is Rs 190,000. The portfolio’s beta is 0.95. For complete hedging, he needs to sell 0.95 x 190,000 of the futures, that is Rs 180,500. On February 10, 2002, Nifty is at 1,125. So he will sell 200 Nifties and his short position on the Nifty futures will expire on March 10, 2002 worth Rs 225,000. On March 5, 2002, the Nifty falls to 963. This drop was due to the budget announcement on February 28, 2002. On March 5, 2002, he buys back his futures thus ending his hedging. His portfolio value came down to Rs 155,000 and his loss on portfolio amounted to Rs 35,000. His profits on the futures hedging are Rs 32,400 (Rs 2,25,000 – Rs 1,92,600). Hence his net loss is Rs 2,600. Had he not hedged his portfolio, his loss would have been Rs 35,000. If the budget announcement had led to a rise in Nifty, then the investor would have gained.

This strategy of selling index futures may be of great help to a balanced mutual fund scheme which decides to reduce its equity exposure. If the mutual fund actually sells its equity holdings, then such selling would depress equity prices to the disadvantage of the scheme and increase cost and time taken. Instead of actually selling the required portfolio, the mutual fund can opt for selling index futures at much less cost and with a low impact on the cash market. The mutual fund can then, on the one hand undertake actual sale of its holdings, depending on market conditions and realize best possible prices. On the other hand the mutual fund can reduce or unwind the short index futures position correspondingly.

Another advantage of this strategy for mutual funds is that they can preserve the value of portfolio during times of market stress.

Hedging with Long Index Futures:
There are situations in which a person has funds or anticipate funds in the near futures and wants to invest in equity shares. However, investing in the stock market is a time consuming process as a person may need to do equity research and decide his portfolio. Moreover, certain mutual funds, such as closed ended fund, which has received funds through its initial public offering or an open ended fund, which has received funds by selling fresh units, require time for stock selection and investment. During this time, however, the index may rise. Hence, the investor/fund may have to purchase shares at unusually high prices. This risk can be hedged be buying index futures. Later the investor/fund can gradually acquire shares and thereby reduce the long index position corresponding. This strategy, therefore, enables the investor/fund to choose shares carefully and spend more time in placing agres9ive limit orders.

Strategies for Speculation:

There are two strategies for speculation. If the speculator is bullish about the index, then he can buy index futures. If the speculator is bearish about the index, then he can sell index futures.

Long Index Futures: If the speculator thinks that the index will go up, he should buy the index futures. Once a speculator is long index, using the futures market, he gains if the index rises and loses if the index falls.

Consider a speculator who feels that the index will rise. He buys on August 1, 2002, 200 Nifties with expiration date on August 31, 2002. On August 1, 2002, the Nifty August contract cost him Rs 950 and hence his position is worth Rs 190,000. On August 16, 2000 Nifty rose to Rs 970. He sells off his position at Rs 970 to make a profit of Rs 4,000.

Short Index Futures: If the speculator thinks that the market index will fall, he should sell the index futures. Once a speculator is short index using the futures market, he gains if the index falls and loses if the index rises.

Futures are available at different expirations. Longer dated futures are suitable for long term forecasts of index movement and shorter dated futures are more liquid (i.e. one with the highest bid-ask spread). The most overpriced futures contract should be sold.