Everything About Hedging a Stock Portfolio

Hedging a Stock Portfolio

We should now redirect our attention to using Nifty futures to hedge a portfolio of securities. You may be wondering why we should select Nifty futures rather than another option.

It proves important to remember that when we hold a diversified portfolio, we are naturally lowering unsystematic risk. The only factor remaining in this scenario constitutes the systematic risk. This can be addressed by using an index, such as Nifty futures, which accurately reflects market conditions and thus insulates against risk.

I have invested ₹9,50,000 across a range of securities. This includes equities in the banking sector, information technology companies, and pharmaceutical firms.

Sample Portfolio Composition:

Company Sector Investment Amount Portfolio Weight HDFC BankBanking₹1,85,00019.5%InfosysIT Services₹2,40,00025.3%TCSIT Services₹1,95,00020.5%Sun PharmaPharmaceuticals₹1,65,00017.4%Reliance IndustriesConglomerate₹1,65,00017.4%Total₹9,50,000100%

Step 1: Portfolio Beta Calculation

Determining the ‘Portfolio Beta’ constitutes the initial step when hedging a stock portfolio.

Key Principles:

Portfolio beta represents the aggregate of all individual stock betas weighted by their respective investment proportions.

Weighted beta is determined by multiplying the portfolio’s individual stock betas with their respective weightings.

The amount allocated to each security is determined by dividing the investment in that particular security by the total portfolio value.

For example, weightage of HDFC Bank is 1,85,000 ÷ 9,50,000 = 19.5%

Hence the weighted beta of HDFC Bank on the portfolio would be 19.5% × 0.92 = 0.179

The following table calculates the weighted beta of each security in the portfolio:

Weighted Beta Calculation:

Company Investment Weight Beta Weighted  Beta HDFC Bank₹1,85,000 19.5% 0.920.179 Infosys₹2,40,000 25.3%1.150.291  TCS₹1,95,000 20.5% 0.9 50.195 Sun Pharma₹1,65,000 17.4% 0.880.153 Reliance₹1,65,000 17.4% 0.800.139  Total ₹9,50,000 100% 0.957

The sum of the weighted beta provides the overall Portfolio Beta for this portfolio which stands at 0.957. Therefore, if Nifty rises by 1%, it is expected that the portfolio will increase by 0.957%, and if Nifty falls, then the portfolio would be anticipated to drop by an equivalent proportion.

Step 2: Calculate the Hedge Value

The total value of a hedge derives from Portfolio Beta multiplied by the total investment made in the portfolio.

Hedge Value = Portfolio Beta × Portfolio Value

= 0.957 × 9,50,000

= ₹9,09,150

It proves crucial to keep in mind that this constitutes a ‘long only’ portfolio, for which the securities were bought directly from the spot market. We know that hedging involves taking an offsetting position in the futures markets. The hedge value indicates that we need to short futures of ₹9,09,150 in order to hedge a portfolio of ₹9,50,000. This makes perfect sense because we are dealing with a below-market-beta portfolio.

Step 3: Calculate the Number of Lots Required

Nifty futures are currently trading at 18,275, and with the lot size being 50, the contract value of each lot comes to:

Contract Value = Nifty Price × Lot Size

= 18,275 × 50

= ₹9,13,750

Therefore, to short Nifty futures, one will need to acquire a certain number of lots:

Number of Lots = Hedge Value ÷ Contract Value

= 9,09,150 ÷ 9,13,750

= 0.995

The calculation above implies that, in order to appropriately hedge a portfolio of ₹9,50,000 with a beta of 0.957, one needs to short approximately 1 lot of Nifty futures. Since fractional lot sizes are not available, we would short exactly 1 lot.

If we opt to short 1 lot, we’ll achieve near-perfect hedging. This represents an ideal hedging scenario where portfolio size aligns well with contract specifications.

Let us assume Nifty drops by 950 points (or approximately 5.2%), now that we have proceeded with the hedge. This will enable measuring the efficacy of the portfolio hedge.

Nifty Position Analysis

Short Position Details:

Short initiated at: 18,275

Decline in Value: 950 points

Nifty value: 17,325

Number of lots: 1

P&L = 1 × 50 × 950 = ₹47,500

The short position has generated gains of ₹47,500. We shall investigate what could have occurred within the portfolio.

Portfolio Position Analysis

Portfolio Parameters:

Portfolio Value = ₹9,50,000

Portfolio Beta = 0.957

Decline in Market = 5.2%

Expected Decline in Portfolio = 5.2% × 0.957 = 4.98%

Portfolio Loss = 4.98% × 9,50,000

= ₹47,310

Altogether, the Nifty futures position has increased by ₹47,500 whilst the long portfolio has decreased by ₹47,310. This creates a near-zero effect in terms of net change. The negative outcome of the portfolio is counterbalanced with the gains made from the Nifty short position.

I believe you now comprehend how to hedge a portfolio of securities effectively.

Addressing Previously Unanswered Questions

Before we conclude this chapter, let us examine the two unanswered questions from when we discussed hedging single stock positions. Here they are again:

Question 1: What if I take a position in a security that doesn’t have a futures contract? Say, South Indian Bank. Is it possible to hedge my spot exposure there?

Question 2: In the earlier example, the spot position value was ₹2,24,100, but what about positions that are relatively smaller—like ₹50,000 or ₹1,00,000? Is it feasible to hedge these too?

You can employ hedging for securities that do not offer stock futures. Consider you hold ₹5,00,000 worth of South Indian Bank. Simply multiply the security’s beta with its investment value to determine the total hedge value. In this case, assuming the security has a beta of 0.82, the hedging amount will be:

Hedge Value = 5,00,000 × 0.82

= ₹4,10,000

Once you determine the hedge value, divide it by Nifty’s contract value to calculate the number of lots you will need to short in the futures market. This will help secure your spot position.

Regarding the second inquiry, whilst you cannot hedge small positions whose cost proves comparatively reduced compared to the contract worth of Nifty, one can still accomplish this through options. We shall discuss this when we examine options strategies in subsequent modules.

Understanding portfolio hedging techniques enables investors to maintain market exposure whilst protecting against systematic risk—a crucial skill for navigating volatile market conditions effectively.