Futures contracts are one of the most common derivatives used to hedge risk.
consider you have the portfolio of nifty 50 stocks, instead of taking individual stock futures for hedging, people will choose index futures for hedging.
Hello,
Equity derivatives facilitate trading of a component of price risk, inherent to investment in securities. Price risk is nothing but change in the price movement of asset in an unfavourable direction.
This risk is broadly divided into 2 components - Specific risk/Unsystematic risk and Market risk/Systematic risk.
Unsystematic Risk:
It is the component of price risk that is unique to particular events of the company/industry. This risk is inseparable from investing in the securities. This risk could be reduced to a certain extent by diversifying the portfolio.
Systematic Risk:
This is the non-diversifiable component of the price risk. The variation in a security's total returns that are directly associated with overall movements in the general market is the systematic risk. Every portfolio is exposed to market risk. This risk is separable from investment and tradable in the market with the help of index-based derivatives.
When this risk is hedged perfectly with the help of index-based derivatives, only specific risk of the portfolio remains.
Hence, we may say that total price risk in investment in securities = systematic risk + unsystematic risk.
Lets understand Beta - a measure of systematic risk of a security.
It measures the sensitivity of a stock/portfolio in relation to index movement over a period of time, on the basis of historical prices.
Suppose a stock has a beta of 2, this means that a security has moved 20% when the index moved 10%, indicating that the stock is more volatile that the index.
Stocks/portfolios having beta more than 1 are called aggressive and having beta less that 1 are called conservative.
To calculate beta of a portfolio, one calculates the weighted average of betas of individual stocks based on their investment proportion.
Now lets manage the systematic risk:
One can hedge by the use of index futures to protect the value of this portfolio from expected fall in the market. If prices fall, you make a loss in the cash market and a profit in the futures market and vice-versa.
How many contracts do you have to sell to make a perfect hedge?
Assume you have a portfolio worth Rs.5,00,000 in cash market. Now a perfect hedge means if you make a Rs.50,000 loss in cash market then you should make Rs.50,000 profit in the futures market. We use the hedge ratio for this.
Hedge ratio is calculated as:
Number of contracts for perfect hedge = Vp * βp / Vi
Vp – Value of the portfolio
βp – Beta of the portfolio
Vi – Value of index futures contract = futures index level * contract multiplier.
Assume Beta of portfolio is 1.2 and benchmark index level is 8000, then
Hedge ratio = (5,00,000*1.2/8000) = 75 indices
Since one futures contract has a lot size of 75, you will hedge using 75/75 = 1 contract.
Similarly, we can use single stock futures to manage the risk of equity investment in cash market.