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  • SPECIAL REPORT
  • JUNE 8, 2000

Index Futures - That's what is coming to India! : (Understanding Derivatives - Part III)

Mr. Nimish Desai has one a considerable amount of research on some companies and he has selected 12 scrips which he feels will do exceedingly well, even if the market has a whole does not show substantial gain. After having built his portfolio of Rs 1 million he adopts a wait and watch approach. Being an experienced player, he knows that if some adverse news hits the economy, all stocks will decline in value. So he would like to be in a position, that if the market remains steady, he makes profits, and in case the market falls, he should minimize his losses.

Nimish therefore does some further exploration and finds that the average volatility of the scrips in his portfolio vis--vis the Nifty is 1.2. That is, if the Nifty increased by 1%, the improvement of the overall sentiment would cause an increase of 1.2% in the value of Nimish's portfolio. Like wise, if the value of the index decreased by 1%, the value of his portfolio decreased by 1.2% purely because of poorer sentiment.

Nimish does not want to bear this uncertainty. All he had to do was to get into a kind of arrangement, that a loss in index would mean an increase in his portfolio value, or the gain in Index mean a loss for him in his portfolio value. This can be achieved by short selling the index in such a quantum that the gain on a unit decrease in the index would offset the losses on the rest of his portfolio. This is achieved by multiplying the relative volatility of the portfolio by the market value of his holdings. Therefore, Nimish would be selling

1.2 * I million = 1.2 million worth Nifty.

Now let us study the gain / loss that accrues to Nimish because of the arrangement

Index up 10% Index down 10%
Gain / (Loss) in Portfolio Rs 120,000 (Rs 120,000)
Gain / (Loss) in Futures (Rs 120,000) Rs 120,000
Net Effect Nil Nil

As we see, that Nimish is completely insulated from any losses arising out of poor sentiment. But as a cost, he has to forego any gains that arise out of improvement in the overall sentiment. One would be justified in asking then why should Nimish invest in equities at all if the gains in cash market will be offset by losses in futures market. The idea is, Nimish is expecting his portfolio to outperform the market. Irrespective of whether the market goes up or not, his portfolio value would increase.

To summarize the chapter on hedging with index futures, we could say,

  • In hedging, you are not looking to make a profit.
  • You have invested in stocks that will outperform the market.
  • The index you have used is a good representative of the entire stock market.
  • You do not want to bear losses that would arise out of adverse events that affect the entire economy.
  • You will not stand to gain from any such news either.
  • Hedging may not always lead to a better outcome. However, it may lead to a more certain outcome.

    One another key derivative that has yet to be discussed by us is the Option, which is tackled in the subsequent article.

  • This article is one of four articles in a series to understanding derivatives. Read Part I, Part II and Part IV of this series

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