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IIPM/Prof.

Ramakar Jha/Portfolio Management/Hedging of Portfolio/Handout # 2

IIPM/Prof. Ramakar Jha/Portfolio Management/Hedging of Portfolio/Handout # 2

Handout 2:

Hedging Effectiveness of a Market Portfolio (Index)

Market index is used by many investors to hedge their risk/exposure. Various index futures are
traded by investors in order to manage their risk. NSE commenced trading in Index Futures on June 12, 2000. The Nifty futures contracts are based on the popular market benchmark S&P CNX Nifty Index. S&P CNX Nifty is uniquely equipped as an index for the index futures market owing to (a) low market impact cost and (b) high hedging effectiveness. The good diversification of S&P CNX Nifty will generate low initial margin requirements. Finally, S&P CNX Nifty is calculated using NSE prices, and NSE is the most liquid exchange in India, thus making it easier to do arbitrage for S&P CNX Nifty index futures. Suppose you have some portfolio, and you use index futures for hedging. A good index is one, which gives high hedging effectiveness, i.e. the index should correlate well with your portfolio whatever it may be. A good index would give a very high risk reduction when a portfolio owner short sells the index futures. S&P CNX Nifty correlates better with all kinds of portfolios in India as compared with other indices. This holds for all kinds of portfolios, not just those that contain index stocks. Why Hedging? Investors studying the market often come across a security which they believe is intrinsically undervalued. It may be the case that the profits and the quality of the company make it seem worth a lot more than what the market thinks. A stock-picker carefully purchases securities based on a sense that they are worth more than the market price. When doing so, he faces two kinds of risks: His understanding can be wrong, and the company is really not worth more than the market price; or, The entire market moves against him and generates losses even though the underlying idea was correct.

There is a simple way out. Every time you adopt a long position on a security, you should sell some amount of Nifty futures. This offsets the hidden Nifty exposure that is inside every long security position. Once this is done, you will have a position which is purely about the performance of the security. The position LONG WIPRO + SHORT NIFTY is a pure play on the value of WIPRO, without any extra risk from fluctuations of the market index. When this is done, the stock-picker has hedged away his index exposure. The basic point of this hedging strategy is that the stock-picker proceeds with his core skill, i.e. picking securities, at the cost of lower risk. Warning: Hedging does not remove losses. The best that can be achieved using hedging is the removal of unwanted exposure, i.e. unnecessary risk. The hedged position will make less profit than the un-hedged position, half the time. One should not enter into a hedging strategy hoping to make excess profits for sure; all that can come out of hedging is reduced risk. How do we actually Hedge? Step1: We need to know the beta of the security, i.e. the average impact of a 1% move in Nifty upon the security. If betas are not known, it is generally safe to assume the beta is 1. Suppose we take LUPINLAB, whose beta is 0.5826, and suppose we have a LONG LUPINLAB position of Rs.710 * 1000 shares = Rs.710,000. Step 2: The size of the position that we need on the index futures market, to completely remove the hidden Nifty exposure, is 0.5826 * 710,000, i.e. Rs.413,646. Suppose Nifty is at 4355, and the market lot on the futures market is 50. Hence each market lot of Nifty is Rs.217,750. To sell Rs.413,646 of Nifty we need to sell two market lot. We sell two market lot of Nifty (50 nifties) to get the position: LONG LUPINLAB Rs.710,000 SHORT NIFTY Rs.435,500

Step 3:

Step 4:

This position will be essentially immune to fluctuations of Nifty. The profits/losses position will fully reflect price changes intrinsic to LUPINLAB, hence only successful forecasts about LUPINLAB will benefit from this position. Returns on the position will be roughly neutral to movements of Nifty. Example: 1. Shyam adopts a position of Rs.10,00,000 (Rs.160 * 6250 shares) LONG MTNL on date 5th July 2007. He plans to hold the position till the 26th. 2. Suppose the beta of MTNL happens to be 0.9199. 3. Hence he needs a short position of Rs.9,19,900 on the index futures market to totally remove his Nifty exposure. 4. On date 5th July 2007, Nifty is 4350 and the nearest futures contract (with expiration 26th July 2007) is trading at about 4355. Hence, each market lot of the futures (50 nifties) is worth Rs.217,750. To sell Rs.9,19,900 of Nifty, we need to sell 5 lots (by rounding off to the nearest market lot). 5. He sells 5 market lots of Nifty (300 nifties) to get the position: 1. LONG MTNL Rs.10,00,000 2. SHORT NIFTY Rs.13,06,500 6. 10 days later, Nifty crashed by 10% because of instability in the government. 7. On Thursday, Shyam unwound both positions. His position on MTNL lost Rs.93,750 since MTNL had dropped to 145 (roughly beta times market fall i.e., 0.9199 * 10% = 9.199%). His short position on Nifty June futures earned Rs.132,000 [(4355 - 3915) * 300]. Overall, he earned Rs.38,250. Nuances: 1. How do I find out the beta of a security? The betas of major securities are available in the NSE Newsletter or over the Internet on http://www.nse-india.com. Note that the security prices and betas used in this chapter are taken from Capitaline Database.

The second outcome happens all the time. A person may buy Reliance at Rs.1700 thinking that it would announce good results and the security price would rise. A few days later, Nifty drops, so he makes losses, even if his understanding of Reliance was correct. There is a peculiar problem here. Every buy position on a security is simultaneously a buy position on Nifty. This is because a LONG RELIANCE position generally gains if Nifty rises and generally loses if Nifty drops. In this sense, a LONG RELIANCE position is not a focused play on the valuation of Reliance. It carries a LONG NIFTY position along with it, as incidental baggage. The stock-picker may be thinking he wants to be LONG RELIANCE, but a long position on Reliance effectively forces him to be LONG RELIANCE + LONG NIFTY. Even if you think WIPRO is undervalued, the position LONG WIPRO is not purely about WIPRO; it is also partly about Nifty. Every trader who has a LONG WIPRO position is forced to be an index speculator, even though he may have no interest in the index. It is useful to ask: does the person feel bullish about WIPRO or about the index? Those who are bullish about the index should just buy Nifty futures; they need not trade individual securities. Those who are bullish about WIPRO do wrong by carrying along a long position on Nifty as well.

Portfolio Management: Prof Ramakar Jha

Portfolio Management: Prof Ramakar Jha

IIPM/Prof. Ramakar Jha/Portfolio Management/Hedging of Portfolio/Handout # 2

IIPM/Prof. Ramakar Jha/Portfolio Management/Hedging of Portfolio/Handout # 2

2. What if I am still stuck without a beta estimate? If a beta is not known, it is generally useful to guess that the beta of an unknown security is near 1. In other words, a speculative long position of Rs.500,000 on any security should be accompanied by selling Rs.500,000 of Nifty in order to obtain a complete hedge. This (slightly wrong) hedged position is always much better than a totally un-hedged position (i.e. not selling any Nifty). Of course, knowing the true beta gives the most accurate hedge. 3. Does this only work for indexsecurities? No, this works for any securities in the country. Some index securities have a weak link to the index, and some nonindex securities have a very tight link with the index. 4. How much risk reduction do I gain? It varies from security to security. The naked LONG SILVERLINE position is around twice the risk of the hedged position LONG SILVERLINE + SHORT NIFTY. The risk reductions obtained range of 25% to 60%. Suppose the daily returns of a security has a variance of V. Then the variance of the fully hedged position is V - m22 where m is the standard deviation of daily returns on Nifty. Typically, m is around 1.6 percent/day. For example, if SILVERLINE has a variance of 9 and a beta of 1.2, then the fully hedged position has a variance of 5.31. Through this formula, we can precisely quantify the magnitude of the risk reduction that complete hedging delivers. 5. Will hedging always help if my forecast about the security is wrong? It depends. If the forecast about the security itself is wrong, then hedging is no help. If the forecast goes wrong because Nifty crashes, then a complete hedge will reimburse these losses. 6. Nifty futures with several different expirations are available at the same time. Which one should I use? There are three criteria: liquidity, expiration date, and potential mispricings:

In addition, with the index futures market, a third and remarkable alternative becomes available: 3. Remove your exposure to index fluctuations temporarily using index futures. This allows rapid response to market conditions, without panic selling of shares. It allows an investor to be in control of his risk, instead of doing nothing and suffering the risk. The idea here is quite simple. Every portfolio contains a hidden index exposure. This statement is true for all portfolios, whether a portfolio is composed of index securities or not. In the case of portfolios, most of the portfolio risk is accounted for by index fluctuations (unlike individual securities, where only 3060% of the securities risk is accounted for by index fluctuations). Hence a position LONG PORTFOLIO + SHORT NIFTY can often become one-tenth as risky as the LONG PORTFOLIO position! Suppose we have a portfolio of Rs.1 million which has a beta of 1.25. Then a complete hedge is obtained by selling Rs.1.25 million of Nifty futures. How do we actually Hedge a Portfolio? Step 1: We need to know the beta of the portfolio, i.e. the average impact of a 1% move in Nifty upon the portfolio. It is easy to calculate the portfolio beta: it is the weighted average of securities betas. Suppose we have a portfolio composed of Rs.1 million of Hindalco, which has a beta of 0.9266 and Rs.2 million of Hindustan Lever, which has a beta of 0.8961, then the portfolio beta is (1*0.9266 + 2*0.8961)/3 or 0.9063. If the beta of any securities is not known, it is safe to assume that it is 1. Step 2: The complete hedge is obtained by adopting a position on the index futures market which completely removes the hidden Nifty exposure. In the above case, the portfolio is Rs.3 million with a beta of 0.9063, hence we would need a position of Rs.2.72 million on the Nifty futures. Suppose Nifty is 4355, and the market lot on the futures market is 50. Each market lot of Nifty costs Rs.217,750. Hence we need to sell 13 market lots, i.e. 650 Nifties to get the position: LONG PORTFOLIO Rs.30,00,000 SHORT NIFTY Rs.28,30,750. This position will be essentially immune to fluctuations of Nifty. If Nifty goes up, the portfolio gains and the futures lose. If Nifty goes down, the futures gain and the portfolio loses. In either case, the investor has no risk from market fluctuations when he is completely hedged. The investor should adopt this strategy for the short periods of time where (a) the market volatility that he anticipates makes him uncomfortable, or (b) when his financial planning involves selling shares at a future date and would be affected if Nifty drops. It does not make sense to use this strategy for long periods of time if a two-year hedging is desired, it is better to sell the shares, invest the proceeds, and buy back shares after two years. This strategy makes the most sense for rapid adjustments. Another important choice for the investor is the degree of hedging. Complete hedging eliminates all risk of gain or loss. Sometimes the investor may be willing to tolerate some risk of loss so as to hang on to some risk of gain. In that case, partial hedging is appropriate. The complete hedge may require selling Rs.3 million of the futures, but the investor may choose to only sell Rs.2 million of the futures. In this case, two-thirds of his portfolio is hedged and one-third of the portfolio is held un-hedged. The exact degree of hedging chosen depends upon the appetite for risk that the investor has.

Step 3: Liquidity: Using the most liquid of them (i.e. the one with the tightest bidask spread) saves money on impact cost. Expiration date: If the speculative position is a twoweek view, then its convenient if the index futures that is used also has at least two weeks to go. Potential mis-pricings: Finally, it never hurts to be clever and sell a futures contract which is somewhat overpriced. This will not only do the job of hedging, but it could also yield some profits out of the mis-priced futures. Hence it helps to check the market price of all available futures contracts against their fair values, and try to use the most overpriced contract as part of the hedging. Hedging a Portfolio The only certainty about the capital market is that it fluctuates! A lot of investors who own portfolios experience the feeling of discomfort about overall market movements. Sometimes, they may have a view that security prices will fall in the near future. At other times, they may see that the market is in for a few days or weeks of massive volatility, and they do not have an appetite for this kind of volatility. The union budget is a common and reliable source of such volatility: market volatility is always enhanced for one week before and two weeks after a budget. Many investors simply do not want the fluctuations of these three weeks. This is particularly a problem if you need to sell shares in the near future, for example, in order to finance a purchase of a house. This planning can go wrong if by the time you sell shares, Nifty has dropped sharply. When you have such anxieties, there are two alternatives: 1. 1 Sell shares immediately. This sentiment generates panic selling which is rarely optimal for the investor. 2. 2 Do nothing, i.e. suffer the pain of the volatility. This leads to political pressures for government to do something when security prices fall.

Portfolio Management: Prof Ramakar Jha

Portfolio Management: Prof Ramakar Jha

IIPM/Prof. Ramakar Jha/Portfolio Management/Hedging of Portfolio/Handout # 2

Example: Table: Example of hedging a portfolio This example deliberately uses a small portfolio of small securities (each of the securities in this example has a low market capitalization); in practice, the effectiveness of hedging would be greater with larger portfolios of larger securities. The hedging strategy is designed to dodge quarterly result related volatility for the quarter end announcement of June 2007. The hedging strategy is initiated on 22nd June 2007 and ended on 5th July 2007. Over this period, the portfolio gains 26,775 (5.56%), while the Nifty Futures Loses 121.75*100 = 12,175 (2.88%). Security ITC ORIENTBANK CIPLA LUPIN SIEMENS Portfolio Nifty 22nd June 2007 154.00 213.00 209.00 701.00 1311.00 481,300 4232.75 5th July 2007 156.10 223.00 216.25 720.95 1410.25 508,075 4354.50 Profit/Loss

26,775 (5.56%) 121.75 (2.88%)

1. On 22nd June 2007, Shyam has a portfolio composed of five securities: ITC (100 shares, value Rs.154), ORIENTBANK (200 shares, value Rs.213), CIPLA (100 shares, value Rs.209), LUPINLAB (200 shares, value Rs.701), and SIEMENS (200 shares, value Rs.1311). The total portfolio value is 481,300 and the five securities have weights (3.20%, 8.85%, 4.34%, 29.13%, 54.48%). Shyam does not want to worry about quarterly result related fluctuations from 22nd June 2007 till 10th July 2007. 2. The five securities have the following betas: ITC (beta 0.7970), ORIENTBANK (beta 1.3615), CIPLA (beta 0.7973), LUPINLAB (beta 0.5762), and SIEMENS (beta 1.1140). Hence the portfolio beta works out to (0.0320*0.7970 + 0.0885*1.3615 + 0.0434*0.7973 + 0.2913*0.5762 + 0.5448*1.1140) or 0.9554. 3. For complete hedging he will need to sell futures worth 0.9554*481,300, i.e. Rs.459,834.02. On 22nd June 2007, Nifty is at 4232.75. So he decides to sell 100 Nifties. 4. Hence Shyam supplements his portfolio with a short position on the Nifty futures with expiry on 26th JULY worth Rs.423,275. 5. On 5th July he buys back futures at a higher price and ends his hedge (see Table above). His loss on the futures hedging was Rs.12,175 and his gains on the portfolio were Rs.26,775. Thus the net gain is Rs.14,600. If he had not hedged, and the market drops down, he would have lost. In this example, the quarterly result announcement led to a rise in Nifty, so the short position on the futures market generated losses. If the quarterly result announcement had led to a drop in Nifty, then the investor would have lost money on his securities portfolio, and gained money on the futures position. In either event, he would be hedged, i.e. he would neither gain nor lose from index fluctuations.

Portfolio Management: Prof Ramakar Jha

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