Risk minimisation: Focus of hedging

Anup Menon

THE objective of the traditional type of hedging is to reduce the risk of the extent to which the portfolio is exposed.

The risk is reduced by making an additional investment, whose risk cancels out the initial risk. Consider this: A mutual fund manager holds assets worth Rs. 50 crores. Given the state of the market, he wants to protect his fund. The options open to him are:

*Liquidate a portion of the assets and hold cash

*Sell index futures equal to the value of the portfolio

In the latter case, the benefits of using index futures becomes apparent. Using the first strategy means the portfolio manager has to liquidate a portion of his assets. Normally, as the risk is greater in a falling market, his ability to get a good price when selling is remote. Normally, in such circumstances, the fund manager is forced to sell some of his premium holdings. For instance, the UTI, which had to sell large volumes of Hindustan Lever and ITC to meet dividend payments under the US-64.

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Further, all the stocks in the portfolio may be solid ones, which would generate excess returns over the long term. On the other hand, by using index futures, the fund manager can avoid the need to sell individual stocks. At the same time, he can cover the value of the portfolio against any adverse movement in prices.

Making the perfect hedge, where the manager can completely cover his market risk, is important as the portfolio gets immunised. But this may not be a good strategy as it will generate only the risk-free rate of return. Traditional capital market theory states that investors are rewarded for the market risk component in their portfolios.

By executing a perfect hedge, market risk is completely eliminated, thereby not earning excess return. However, in practice, finding a perfect hedge is next to impossible. An important characteristic of a perfect hedge is that the movement of the portfolio must be perfectly correlated with the movement of the underlying index.

Uses of index futures

Fund managers can use index futures in these ways:

Portfolio performance can be segregated into two portions based on stock selection and market timing. Stock selection relates to the ability of the fund manager to spot stocks that are mispriced, while market timing is concerned with his ability to forecast market movements. Let us envisage a situation where a fund manager identifies a share that is underpriced but has a high beta value.

Assuming that the market may fall, the fund manager is in a fix. From the point of view of stock selection the decision warrants going long on the stock but market timing suggests otherwise. This is where the use of index futures to control beta plays a crucial role. Effectively, index futures permit control of the riskiness of the portfolio without hindering the stock selection decision.

Another important aspect where index futures help is in asset allocation. Returns for a fund depend on the right level of diversification and the choice of assets used to diversify. If there arises a situation where the asset manager is able to identify a different set of assets which would improve the fund's performance, what should he do?

He has two options: The first is to liquidate the existing asset position and the next is to purchase a new set of assets. As such a process requires time, managers can immediately lock in on the returns by using corresponding futures contracts.

With uncertain volatility, funds face problems in terms of redemptions. In the absence on index futures, funds have to invest the money in short-term deposits and other highly liquid instruments. However, the return earned on such assets is lower than those on equity investments. With the introduction of futures, fund managers have a highly liquid option, providing a higher rate of return, in which they can invest their excess funds.

The role of foreign institutional investors in the Indian market has been critical in the recent past. The introduction of index futures as a hedging mechanism may actually attract more foreign funds into the country by way of FII investments. An investor who invests in foreign markets is exposed to two sources of risk -- market risk and the foreign exchange risk associated with the country.

When the position is liquidated, the proceeds are converted to the home currency of the international investor at the prevailing exchange rate. By taking an opposite position in the futures market, the investor's risks are confined to margin payments and receipts which would be much lower than the actual position in the stocks.