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Hedging is a method of reducing the risk
of loss caused by price fluctuation. It consists of the purchase
or sale of equal quantities of the same or very similar commodities,
approximately simultaneously, in two different markets with
the expectation that a future change in price in one market
will be offset by an opposite change in the other market.
There are two aspects or objective of
hedging
isolating stock selection
isolating market exposure.
Isolating Stock
Selection
A fund manager may want to isolate the
firm or sector specific exposure. In order to isolate the
stock selection dimension, the investor might remove market
exposure by use of a short position in stock index futures.
You can reduce your risk in your portfolio by taking short
positions in the index (equivalent amount of your portfolio).
A sample portfolio with their respective
beta values:
| Share |
No of Shares |
Shares Price(Rs) |
Shares Beta |
Total exposure(Price
X No. of share
exposure X Beta value) |
| Reliance |
2000 |
380 |
0.90 |
6,84,000 |
| Infosys |
500 |
3900 |
1.50 |
29,25,000 |
| Acc |
2000 |
140 |
1.40 |
3,92,000 |
| Total |
|
|
|
40,01,000 |
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Assume that on 20 June, BSE Futures are
trading at 4000.
The market exposure provided by one future
contract (eg. BSE Sensex) is 4000 x 50 = 2,00,000. (One BSE
contract is 50 units). So hedging the portfolio with futures
would involve selling 40,01,000/2,00,000 = 20.005, say 20
contracts.
Now suppose on expiry day your portfolio
value and index is:
| |
Index |
Portfolio |
Gain/loss from Index |
Gain/loss from portfolio |
Net Gain/ Loss |
| Scenario 1 |
3700 |
35,00,000 |
3,00,000* |
(499000) |
(1,99,000) |
| Scenario 2 |
4300 |
45,00,000 |
(3,00,000) |
5,01,000 |
2,01,000 |
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* (4000 -3700) = 300 per contract and
we have sold 20 contracts of index future (one Contract is
50 units) so total gain is 20 x 50 x 300 = Rs 3,00,000
Isolating market
Exposure
One would wish to avoid exposure to non-systematic
risk (risk unique to an individual stock / selection) In other
wards, the intention may be to gain market exposure while
avoiding the risk that the stocks bought may underperform
the market. Such an investor could obtain market exposure
by buying stock index future while keeping the investment
fund on deposit.
Yield enhancement
You can partially invest in the market
anticipating that you will receive money in future.
For example, suppose you expect cash
receipts at a future date but at the same time you want exposure
in the market.
Buy the index equivalent to your future
cash flow.
Later on gradually acquire of stock and
sell equal amount of index future in the market.
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