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Fund Managers - Insulate your risk!

Jun 23, 2000

The stock markets face their periods of stress. There are certain times of the year, when markets generally tend to be in bear phase for one reason or the other. It could be year-end profit booking, or a liquidity crunch for advance tax payments. The fund manager also faces period of uncertainty when the markets could swing in either direction, a classic example of the same being the month of February, the end of which is marked by the presentation of the Union Budget. Here, we shall explore how a fund manager could insulate his portfolio from the vagaries of the stock market. Consider a fund called the Good Returns Fund, which has gained by 45% in the last three months. The markets are tentatively poised looking at the government's latest divestment proposal. If the divestments were approved, the markets would react favourably to the same. If the reforms however fall through in the Parliament, the markets might react negatively to the same. The fund manager does not wish to take chances with the gains his fund is showing and wishes to lock-in his NAV for a specific period of time which can extend upto a maximum of 90 days (since that is the longest maturity that an index future contract can presently have) .

Here, the fund manager could sell index futures in proportion to the volatility of his portfolio vis-a-vis the index (measured by the fund beta). Let us assume the beta for the Good Returns Fund is 1.15, and the corpus size is Rs 5,000 million. Therefore, the fund manager would look to sell index futures worth Rs 5,000 million * 1.15 = Rs 5,750 million if he wishes to hedge his entire portfolio. The fund manager could also look to hedge part of his portfolio. Let us see two scenarios - one of a partly hedged portfolio, and one for a fully hedged portfolio.

A fully hedged portfolio:
  Index up 10% Index down 10%
Gain/ (Loss) in Portfolio Rs 57.5 m (Rs 57.5 m)
Gain/ (Loss) in Futures (Rs 57.5 m) Rs 57.5 m
Net Effect Nil Nil

A partly hedged portfolio: (50% hedged)
  Index up 10% Index down 10%
Gain/ (Loss) in Portfolio Rs 57.5 m (Rs 57.5 m)
Gain/ (Loss) in Futures (Rs 28.75 m) Rs 28.75 m
Net Effect Rs 28.75 m (5.75% increase) (Rs 28.75 m) (5.75% decrease)

In another case, the fund manager may simply want to lock-in his portfolio returns till the book closure date of his fund, which may be some weeks away. In the absence of a hedging instrument, the fund manager may lose all his previous effort and hard work due to the vagaries of a volatile market. The fund manager would then rather look to secure the NAV procured for his investors where the use of Index futures is indispensable.

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