The Hindu Business Line : To hedge or not to hedge

Hedging portfolio risk is weighing on every trader’s mind at present. This article shows that hedging is not optimal in our market unless the horizon is three months or less. In other cases, traders would do well to adopt strict money management rules to manage portfolio risk.

B. Venkatesh

The continual rise in asset prices is taking its toll on the market participants — extreme greed is now turning into gradual fear as traders are worried about which way the market will turn. It is not so much the actual decline but being caught unawares, that has them concerned.

Unfortunately, no discerning analyst would venture to forecast a market turn, before the event. This directional risk leads to an important question: Should traders hedge their core portfolio? What should be the optimal hedging instrument?

This article provides answers to these questions. Specifically, it shows that hedging may not be a viable option to individual traders unless the hedging horizon is three months or less. Otherwise, it is optimal to manage the portfolio with strict money management rules instead of incurring high hedging costs.

Hedging process

Hedging refers to taking a counter-position to the underlying portfolio with a view to protecting the downside risk. It is important to understand that the hedge is set-up for the entire portfolio.

Suppose an investor has a portfolio worth Rs 15 lakh consisting of 10 stocks. She will not hedge each stock separately. Hedging in this case requires taking a short position in the hedging instrument against the portfolio.

At present, the stock market provides only two hedging instruments — the near-month options and futures.

Institutional investors can use OTC derivatives such as Total Return Swaps to hedge their portfolio. The choice of the hedging instrument will depend on the investor’s hedging horizon and objectives.

Suppose the portfolio has to fold in March 2008 and the investor would like to protect at least 90 per cent of the unrealised gains. It would then be optimal to sell index futures against the portfolio.

Assuming a one-to-one correlation between portfolio returns and index futures for sake of simplicity, the investor will short four index futures at 6,000 (15 lakh times 0.90 upon 6,000 times 50).

If the investor wants a complete hedge, she can short five futures contracts. But setting up a perfect hedge will not be optimal. Any gain in the portfolio would be offset by an equal loss on the short futures position. It would instead make sense to fold the portfolio and invest the proceeds in a short-term money market instrument till the hedging horizon.

Using index put options makes sense if the investor wants downside protection, yet unlimited upside potential. The number of options will depend on the option delta.

Hedging Horizon

Hedging horizon refers to life of the hedge. If a portfolio folds in 2011, the hedging horizon is three years. Hedging horizon is important because setting up a hedge just to protect unrealised gains on a portfolio that doesn’t have a specific horizon is expensive, even in normal markets.

As it is, hedging has its risks. Shorting index futures with a three-year hedging horizon exposes the portfolio to high rollover risk.

This is the risk that the investor has to roll over the index futures at a higher rate every month through the hedging horizon. For instance, if the investor rolls over the January contract from 6200 to the February contract at 6225, 25 points times 50 (size of each Nifty contract) is the additional hedging cost due to rollover.

Rolling over index options would be costlier because an investor has to pay premium to buy puts. The hedging costs drags down portfolio returns, as options typically expire worthless. It would be optimal to limit the hedging horizon to three months or less.

Managing risk

The objective is to capture upside potential without exposing the portfolio to much downside risk, yet minimise the hedging cost. Here is a simple risk-minimising process:

If the hedging horizon is more than three months and the objective is to protect the unrealised portfolio gains, reduce portfolio exposure. Traders should take profits by selling 50 per cent of their existing holdings.

The downside risk on the remaining 50 per cent holdings should be actively managed with trailing stops. No hedging is required.

If the hedging horizon is three months or less, the investor should buy index puts. Buying in-the-money puts may be advisable when the market is up on the hedging day. The entire hedging process involves two rollovers into the hedging horizon. This will come at a cost but the portfolio is exposed to upside potential.

It is important to set up this hedge after selling stocks that carry returns of 10 per cent or less; it would be costly to set up the hedge otherwise.

Some investors have highly concentrated portfolios; a single stock could constitute nearly 50 per cent of the total portfolio. Investors in such cases may be better off substituting relevant single-stock futures or options instead of index contracts in the above case.

(The author is a Chennai-based investment strategist. He can be reached at enhancek@gmail.com)

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