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Using index futures: A case for hedging - II

Kshama Fernandes

Continuing with last week's topic, we discuss here the various ways in which futures contracts can be used by market participants. Futures markets provide an excellent avenue for hedging, speculation and arbitrage.

Many of the participants of the futures markets are hedgers. Their aim is to use futures markets to reduce a particular risk that they face. This risk may relate to the price of oil, a foreign exchange rate, the level of the stock market or some other variable. A perfect hedge is supposed to completely eliminate risk. But as we know, perfect hedges are rare. So the goal basically ought to be the construction of hedges which perform as close to perfect as possible. How does one go about constructing these hedges? With National Stock Exchange's (NSE) futures market going live today, we take a look at yet another way in which index futures can be used for hedging.

We continue with the case of Mr Kumar who does stock analysis. He has been studying ITC for some time and believes that the stock is intrinsically overvalued. So he goes ahead and sells shares of ITC thus taking on a short ITC position of Rs 650,000. Assuming that his understanding of the company is correct and that ITC is in fact worth less than what the market thinks, what could go wrong for him? A rise in the market level. Even the best stockpicker, who shorts, faces the risk of loss due to a rise in the market. So is the case with Kumar. A few days later, the S&P CNX Nifty rises and he makes losses even though his basic understanding of ITC was correct.

Why does this happen? It happens because every sell position on a stock is simultaneously a sell position on the index. A short ITC position generally gains if S&P CNX Nifty falls and generally loses if S&P CNX Nifty rises. What does this mean? It means that though Kumar purely wants to be short ITC and has no interest whatsoever in the index, a short position on the stock effectively forces him to be short ITC and short S&P CNX Nifty. Every short position holder is forced to be an index speculator even though he may have no interest in the index. So what should he do to remove the index exposure that he faces?

The technique is simple. Every time he adopts a short position on a stock, he should buy some amount of S&P CNX Nifty futures. This will then offset the hidden index exposure that exists in every short-stock position. Once this is done he will have a position which is purely about the performance of the stock and not the index. Hence for Kumar, the position short ITC + long S&P CNX Nifty is a pure play on the value of ITC, without any extra risk from fluctuations of the market index. The point here is that if one believes that one is skilled at stockpicking, then stockpicking should be what one does, without having to speculate on the index. Index futures enable a stockpicker to beautifully hedge away the index exposure that comes from being short a stock.

Now given that Kumar should buy Nifty futures, how much or how little should he buy? For this he will need to know the "beta" of the stock. (As we know, the beta of a stock gives the sensitivity of the stock to fluctuations in the index, ie the average impact of a 1 per cent move in the index upon the stock. A stock with a beta of 1.2 moves by 1.2 per cent on average when the index moves by 1 per cent and a stock with a beta of 0.8 moves by 0.8 per cent on average when the index moves by 1 per cent). He could either compute the beta himself or use the readily available betas published by NSE. Even if the betas are not known, it is generally safe to assume the beta is 1.

Given that the beta of ITC is 1.2, to completely remove the hidden index exposure, he should take a position of 1.2 * 650,000 on the index futures market. ie Rs 780,000. If the S&P CNX Nifty is at 1300, and the nearest futures contract is trading at 1310 (with a market lot of 200), each market lot is worth Rs 262,000. To buy Rs 780,000 of S&P CNX Nifty he will need to buy three market lots (rounding off to the nearest market lot).

Once he does this, he will have a position of:
Short ITC                          Rs 650,000
Long S&P CNX Nifty       Rs 786,000

This position will essentially be immune to fluctuations in the index. The profits/losses on this position will fully reflect price changes intrinsic to the stock, and hence only successful forecasts about the stock will benefit from this position.

Hence if you are a stockpicker and would like to go short a stock that you believe is overvalued, you could easily hedge away the unnecessary risk of index movements by taking an appropriate position in the index futures market. However as mentioned earlier, hedging does not remove losses. At best it succeeds in removing unnecessary exposure and reducing risk. (For details refer to NSE's Workbook on Derivatives.)

ALSO SEE
Using index futures: A case for hedging I

The author is a faculty member at the Department of Management Studies, Goa University. She handles capital markets and derivatives.

Derivatives Center

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