Illustration 1: Selling stock index futures to protect the portfolio 

Sometimes, you may have a view that the market will fall in the future. At other times, you may feel that the market is going to have a few days of massive volatility, and you do not want to bear that amount of volatility. The union budget, and period of onset of monsoon etc. are such events. Many investors do not want to speculate on such events. When investors have such anxieties, stock index futures provides a convenient alternative to remove exposure to the stock market for a short time. Investors having a portfolio can sell the stock index futures and have an hedged position. 

How to do this actually? 
1. The beta of the portfolio needs to be calculated. Beta is a measure of likely change in the value of the portfolio in relation to the change in the stock price index. Beta of the portfolio is the weighted average (weights in proportion to the value of holding) of betas of the shares in the portfolio. The values of betas of individual shares are calculated by regression of daily return on the share and daily return on the index. NSE web site gives beta values of for the actively traded shares. 

2. The value of the portfolio is multiplied by the value of beta to get the value of the futures position to be sold. 

3. Let us assume a. Portfolio value is Rs.30 lakhs. b. Beta of the portfolio is 1.2 c. Current value of NSE NIfty is 3410. d. July NIfty future is selling at 3445. 

4. The position to be taken in futures is portfolio value multiplied by beta i.e. Rs.36 lakhs (Rs.30 lakhs*1.2) 

5. The number of future contracts to be sold is the position to be taken in futures divided by the value of one futures contract. Each futures contract will be for Rs.1,72,250 (3445*50). Hence number of contracts is Rs.36 lakhs/172250 = 20.90 contracts. Let us round it to 21 contracts. 

6. What will happen if after 15 days Nifty goes down to 3000. The July future may go down to 3030. Investor buys back the futures contract now and thus squares off the futures position. The profit made on the futures position would be Rs.4,35,750 ((3445-3030)*50*21). 

7. The loss suffered on cash position is Rs.4,32,845 [{(3410-3000)/3410}*1.2*Rs.30 lakhs] 

8. Thus the hedge in futures market compensates for the fall in spot market prices. 

Warning:
Hedging does not always make money. If the index has gone up in stead of going down futures position will show a loss and the investor has to fund it if required by reducing his portfolio. The best that can be achieved using hedging is the removal of unwanted exposure. The hedged position will make less profits than the un-hedged position, half the time. 

The investor should adopt this strategy for the short periods of time where the market volatility that he anticipates makes him uncomfortable, or when he plans to sell his holdings in the near future. 

Illustration 2: Buy stock index futures to hedge planned purchase of equity shares in the future

A mutual fund has received large amount of funds which are to be invested in the stock market. The fund managers need time to research stocks and carefully pick stocks that are expected to do well. After selecting the stocks, they cannot rush to the market and place orders to buy as it would generate large ‘impact costs’. The execution would be improved substantially if they could instead place limit orders and accumulate the shares at favorable places. But all this effort takes time, and during this time the market may go up. 

Index futures offer a convenient way of acquiring exposure to the stock market. The mutual fund can buy futures contracts for the value of the funds to be invested immediately. As and when its buys the shares it wants it can sell contracts equal to that amount. This hedging ensures that the fund will buy the shares it wants close to their current prices. Any increase in the market would be compensated by the profits it makes on the futures position. 

Once again it is to be noted that if market goes down in price, the mutual fund does not benefit. The hedge locks in the prices. Hedger does not lose if prices go up. He does not gain if prices come down. Options provide an opportunity to the hedger to enjoy profits if the market moves in a favorable position and protect him if the market moves in an unfavorable position. 

Illustration 3: Hedged long position in a share (Long Stock/Short Futures) 

A stock picker picks a share to outperform the market due to reasons specific to the stock. A position in that stock may not provide profit to him if the general market goes down. Every buy position on a stock is simultaneously a buy position on the general market. The exposure to the general market can be removed by selling an index future. Then the position becomes a focused play on the performance of the stock. The earliest hedge funds were involved in similar hedging strategies only. 

Example: 
1. An investor wants to acquire a long position of Rs. 1 Million in GMR Infra. The current market price of Rs.60. The beta of GMR Infra is 1.23 according the NSE site. 

2. Hence he requires a short position of Rs.1.23 million on the Nifty futures market to totally remove his Nifty exposure. 

3. Nifty futures with August maturity is available at 4099. Each contract will have a value of Rs.2,04,950. 6 contracts of Nifty futures need to be sold. 

 4. With this hedge if Nifty goes down, investor will not suffer as his short position in futures will earn him the profit. He will have the benefit of relative performance of GMR INfra to the market. 

Illustration 4. Hedged short position (Short stock/Long futures) 

Stock pickers may be good in identifying shares likely to have a bad performance in the market. Their short positions in such shares may not yield them profits because of a rise in the general market. Stock pickers can create hedged short positions by combining the short position in the stock with a long position in the index future. The mechanics of this strategy are exactly similar to the creating of a hedged long position in the stock.