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Hedging in Equity and Commodity trading

The benefit of trading n index futures is to hedge your portfolio against the risk of trading. In order to understand how one can protect his portfolio from value erosion we have understand hedging.

Stocks carry two types of risk - company specific and market risk. While company risk can be minimized by diversifying your portfolio market risk cannot be diversified but has to be hedged. So how does one measure the market risk? Market risk can be known from Beta.

Beta measures the relationship between movement of the index to the movement of the stock. The beta measures the percentage impact on the stock prices for 1% change in the index. Therefore, for a portfolio whose value goes down 11% when the index goes down by 10%, the beta would be 1.1. When the index increases by 10%, the value of the portfolio increases 11%. The idea is to make beta of your portfolio zero to nullify your losses.

Hedging involves protecting an existing asset position from future adverse price movements. In order to hedge a position, a market player needs to take an equal and opposite position in the futures market to the one held in the cash market. Assuming you have a portfolio of Rs. 1 million, which has a beta of 1.2, you can factor a complete hedge by selling Rs. 1.2mn of S&P CNX Nifty futures.

Steps:

1. Determine the beta of the portfolio. If the beta of any stock is not known, it is safe to assume that it is 1.

2. Short sell 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.

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