Hedging Indivdual Stock with Index Futures

No. of Shares 20,000 Index 900

Market Price 100 Contract size 250
Position to be Hedged 2,000,000 Value of One Futures 225,000
Beta of Stock 1.1 No. of Contracts (N
F
) 9.78
No. of Contracts (Rounded off) 10
Current Position in Spot Long Position to be taken in Futures Short
Market Price 88 Index Value 800
% change in MP -12.00% %age change in Index Value -11.11%
-12.22%
Offset the Futures by:
Position to be taken in Futures Long
Value of Stock 1,760,000 Profit /(Loss) in Futures 250,000
Profit/(Loss) (240,000)
Net Effect (Value of Stock + Futures) 2,010,000
0.50%
2,010,000
87.77777778
(Safeguard against fall in Market)
Cash Market Futures Market
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The Hedge helps in reducing the losses on the Stock, if you expect the Market to go
down.

In case the Market and the Stock go up, the Hedge would reduce the gains on the stock.

1-Hedging Individual Stock
Hedging a Portfolio with Index Futures
Scrip MP No. of Shares Market Value Weight Beta Index 1305
A 18.875 18,000 339,750 0.044 1.00 Contract Size 250
B 73.500 16,000 1,176,000 0.152 0.80 Value of One Futures 326,250
C 50.875 7,000 356,125 0.046 0.50 No. of Optimal Contracts 25.19
D 43.625 10,800 471,150 0.061 0.70 No. of Optimal Contracts (Rounded-off) 25
E 54.250 21,000 1,139,250 0.147 1.10
F 47.750 28,800 1,375,200 0.178 1.10 Position to be taken in Futures Market: Short
G 44.500 25,000 1,112,500 0.144 1.40
H 52.875 33,200 1,755,450 0.227 1.20
7,725,425 1.000 1.06
Current Position in Cash Market:
Scrip MP No. of Shares Market Value Index 1295
A 21.625 18,000 389,250 14.6% Change in Index -0.77%
B 81.500 16,000 1,304,000 10.9% Contract Size 250
C 43.875 7,000 307,125 -13.8% Value of One Futures 323,750
D 47.125 10,800 508,950 8.0%
E 45.875 21,000 963,375 -15.4% Offset the Futures by:
F 48.125 28,800 1,386,000 0.8% Position to be taken in Futures Long
G 40.000 25,000 1,000,000 -10.1%
H 50.000 33,200 1,660,000 -5.4%
7,518,700 -2.68%
Cash Market: Futures Market:
Starting Value 7,725,425 Short position in Futures 8,156,250
Ending Value 7,518,700 Long position in Futures 8,093,750
Change (206,725) -2.68% Profit /(Loss) in Futures 62,500
Net Position (Cash + Futures) (144,225) -1.87%
Hedged Position Unhedged Position
(144,225) (206,725)
1100 1,074,525 (206,725)
1150 762,025 (206,725)
1200 449,525 (206,725)
1250 137,025 (206,725)
1295 (144,225) (206,725)
1350 (487,975) (206,725)
1400 (800,475) (206,725)
1450 (1,112,975) (206,725)
1500 (1,425,475) (206,725)
1550 (1,737,975) (206,725)
1600 (2,050,475) (206,725)
1650 (2,362,975) (206,725)
1700 (2,675,475) (206,725)
Cash Market Futures Market
Long
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Portfolio does not
mirror the market.
Hedging has not elinimated the risk, but has
reduced it.
Hedging is far from perfect, may be due to:
1. Beta estimates may not be stable
2. Portfolio is not sufficiently diversefied
and some unsystematic risk still remains.
3. Some stock might have paid dividends
during the hedge which has been ignored.
2HedgingPortfolio-Index Futures
Now Scrip MP No. of Shares Market Value Weight Beta Index 1305
A 18.875 18,000 339,750 0.044 1.00 Contract Size 250
B 73.500 16,000 1,176,000 0.152 0.80 Value of One Futures 326250
C 50.875 7,000 356,125 0.046 0.50 No. of Optimal Contracts 23.68
D 43.625 10,800 471,150 0.061 0.70 24
E 54.250 21,000 1,139,250 0.147 1.10
F 47.750 28,800 1,375,200 0.178 1.10 Position to be taken in Futures Market: Short
G 44.500 25,000 1,112,500 0.144 1.40
H 52.875 33,200 1,755,450 0.227 1.20
I 0.000
J 0.000
7,725,425 1.000 1.06
Current Position in Cash Market: Long
Later Scrip MP No. of Shares Market Value Index 1425
A 20.611 18,000 370,991 9.2% 9.20% Change in Index 9.20%
B 78.907 16,000 1,262,510 7.4% 7.36% Contract Size 250
C 53.214 7,000 372,499 4.6% 4.60% Value of One Futures 356250
D 46.433 10,800 501,477 6.4% 6.44%
E 59.737 21,000 1,254,484 10.1% 10.11% Offset the Futures by:
F 52.580 28,800 1,514,301 10.1% 10.11% Position to be taken in Futures Long
G 50.229 25,000 1,255,718 12.9% 12.87%
H 58.709 33,200 1,949,155 11.0% 11.03%
I
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8,481,136 9.78%
Cash Market: Futures Market:
Starting Value 7,725,425 Short position in Futures 7830000
Ending Value 8,481,136 Long position in Futures -8550000
Change 755,711 9.78% Profit /(Loss) in Futures -720000
Net Position (Cash + Futures) 35,711 0.46%
Cash Market Futures Market
Portfolio now mirrors
the market.
2aHedgingPortfolioIdxFut-mirror
Anticipatory Hedge
Now No. of Shares 100000 Index 1475
Market Price 35 Contract size 250
Position to be Hedged 3,500,000 Value of One Futures 368750
Beta of Stock 1.6 No. of Contracts (N
F
) 15.186
No. of Contracts (Rounded off) 15
Current Position in Spot Short Position to be taken in Futures Long
Later Market Price 38 Index Value 1550 (Safeguard against increase in Market)
% change in MP 8.57% %age change in Index Value 5.08%
8.14%
Offset the Futures by:
Position to be taken in Cash Long Position to be taken in Futures Short
Cost 3,800,000 Profit /(Loss) in Futures 281,250
Profit/(Loss) (300,000)
Effective Cost 3,518,750
per Share 35.1875
37.85 Hedged Position
35.188 25 30 35 40 45
1300 31.56 36.56 41.56 46.56 51.56
1350 29.69 34.69 39.69 44.69 49.69
1400 27.81 32.81 37.81 42.81 47.81
1450 25.94 30.94 35.94 40.94 45.94
1500 24.06 29.06 34.06 39.06 44.06
1550 22.19 27.19 32.19 37.19 42.19
1600 20.31 25.31 30.31 35.31 40.31
Cash Market Futures Market
Stock Price
The Hedge helps in reducing the
cost of acquiring Stock, if you
expect the Market to go up.

However, in case the Market and
the Stock go down, the Hedge
would increase the cost of acquiring
the stock.

Objective was to limit / reduce the cost of acquiring
the shares in an increasing market.
If markets fall instead, the hedge would not be
useful.
3_Anticipatory Hedge
Achieving Target Beta for a Portfolio - To reduce beta, Short Index Futures
Now Scrip MP No. of Shares Market Value Weight Beta Index 1305
A 18.875 18,000 339,750 0.044 1.00 Contract Size 250
B 73.500 16,000 1,176,000 0.152 0.80 Value of One Futures 326250
C 50.875 7,000 356,125 0.046 0.50 Target Beta 0.50
D 43.625 10,800 471,150 0.061 0.70 No. of Optimal Contracts 13.35
E 54.250 21,000 1,139,250 0.147 1.10 No. of Optimal Contracts (Rounded off) 13.00
F 47.750 28,800 1,375,200 0.178 1.10 Position to be taken in Futures Market: Short
G 44.500 25,000 1,112,500 0.144 1.40
H 52.875 33,200 1,755,450 0.227 1.20
7,725,425 1.000 1.0638
Current Position in Cash Market: Long
Later Scrip MP No. of Shares Market Value Index 1250
A 18.080 18,000 325,431 Contract Size 250
B 71.022 16,000 1,136,349 Value of One Futures 312500
C 49.803 7,000 348,620
D 42.338 10,800 457,250
E 51.735 21,000 1,086,434 Offset the Futures by:
F 45.536 28,800 1,311,446 Position to be taken in Futures Long
G 41.874 25,000 1,046,858
H 50.201 33,200 1,666,669
I
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7,379,058
Cash Market: Futures Market:
Starting Value 7,725,425 Short position in Futures 4,241,250
Ending Value 7,379,058 Long position in Futures (4,062,500)
Change (346,367) -4.48% Profit /(Loss) in Futures 178,750
Net Position (Cash + Futures) (167,617) -2.17%
Cash Market Futures Market
4a_To reduce Beta
Achieving Target Beta for a Portfolio - To Increase beta, Go long on Index Futures
Scrip MP No. of Shares Market Value Weight Beta Index 1305
A 18.875 18,000 339,750 0.044 1.00 Contract Size 250
B 73.500 16,000 1,176,000 0.152 0.80 Value of One Futures 326250
C 50.875 7,000 356,125 0.046 0.50 Target Beta 1.80
D 43.625 10,800 471,150 0.061 0.70 No. of Optimal Contracts 17.43
E 54.250 21,000 1,139,250 0.147 1.10 17.00
F 47.750 28,800 1,375,200 0.178 1.10 Position to be taken in Futures Market: Long
G 44.500 25,000 1,112,500 0.144 1.40
H 52.875 33,200 1,755,450 0.227 1.20
7,725,425 1.000 1.06
Scrip MP No. of Shares Market Value Index 1550
A 19.253 18,000 346,545 Contract Size 250
B 74.970 16,000 1,199,520 Value of One Futures 387500
C 51.893 7,000 363,248
D 44.498 10,800 480,573
E 55.335 21,000 1,162,035 Offset the Futures by:
F 48.705 28,800 1,402,704 Position to be taken in Futures Short
G 45.390 25,000 1,134,750
H 53.933 33,200 1,790,559
7,879,934
Cash Market: Futures Market:
Starting Value 7,725,425 Long position in Futures (5,546,250)
Ending Value 7,879,934 Short position in Futures 6,587,500
Change 154,509 2.00% Profit /(Loss) in Futures 1,041,250
Net Position (Cash + Futures) 1,195,759 15.48%
Cash Market Futures Market
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4b_To increase Beta
Alpha Capture
No. of Shares 10,000 Index 2250
Now Market Price 200 3-month Index Futures 2310
Position to be Hedged 2,000,000 Contract size 200
Beta of Stock 1.2 Value of One Futures 462000
No. of Contracts (N
F
) 5.195
No. of Contracts (Rounded off) 5
Current Position in Spot Long Position to be taken in Futures Short
Later Market Price 176 Index Value 2025
% change in MP -12.00% %age change in Index Value -10.00%
-12.00%
Offset the Futures by:
Position to be taken in Futures Long
Value Now 1,760,000 Profit /(Loss) in Futures 285,000
Profit/(Loss) (240,000)
Net Gain/(Loss) 45,000
Stock + Profit 2,045,000
Later Market Price 215 Index Value 2385
% change in MP 7.50% %age change in Index Value 6.00%
Offset the Futures by:
Position to be taken in Futures Long
Value Now 2,150,000 Profit /(Loss) in Futures (75,000)
Profit/(Loss) 150,000
Net Gain/(Loss) 75,000
Stock + Profit 2,075,000
You have identified an undervalued stock to buy, however, are worried that market-
wide decline might drag the stock.
Cash Market Futures Market
5_Alpha Capture
Using Stock Index Futures for Arbitrage
Stock Index Futures also provide opportunity for arbitrage, if the Futures contracts are mis-priced.
A portfolio consisting of T-bills and Stock Index Futures produces the same returns as
a Stock portfolio replicating the Index.
If actual Futures price > Theoretical Futures price, sell futures, and
If actual Futures price < Theoretical Futures price, buy futures.
Consider an investor with Rs. 10 Lacs to invest.
Spot price of NIFTY is 6650 and 2-month Futures is priced at 6670. (Contract Size=50x)
The dividend yield on Index is 4%, while risk-free interest rate is 8%.
The investor wants to invest in a market portfolio and earn the dividend yield.
Fair Price of 2-month NIFTY Futures 6694.48 <-- =6650*EXP((0.08-0.04)*(2/12))
Actual Price of 2-month NIFTY Futures 6670.00
Hence, 2-month NIFTY Futures is underpriced
Instead of buying the Stock in the NIFTY index, investor can replicate the portfolio by :
Buying Futures and investing in T-Bills.
Strategy A: Buy Stocks in NIFTY
Amount Invested in Index stocks 1,000,000
Strategy B: Invest in T-Bills & Buy NIFTY Futures
Amount Invested in T-Bills 1,000,000
Plus:
Buy 2-month NIFTY Futures
Current Value of 2-month NIFTY Futures 6670
Contract Size 50
Value of 1 Futures Contract 333500
No. of Futures Contracts 3.0000 <-- =ROUND(G26/G31,0)
Strategy A: Buy Stocks in NIFTY 10% Increase No Change 10% Decrease
Value of Portfolio 1,100,000 1,000,000 900,000
Dividend Yield 6,667 6,667 6,667
Value of Investment 1,106,667 1,006,667 906,667
Strategy B: Invest in T-Bills & Buy NIFTY Futures
Value of T-Bills 1,000,000 1,000,000 1,000,000
Interest on T-Bills 13,333 13,333 13,333
Value of Investment in T-Bills at the end 1,013,333 1,013,333 1,013,333
Profit/(Loss) of Futures:
Sell 7,315 6,650 5,985
Buy 6,670 6,670 6,670
Profit/(Loss) 645 (20) (685)
Index Multiplier 50 50 50
No. of Contracts 3 3 3
Profit/(Loss) on Index 96,750 (3,000) (102,750)
Value of Investment in T-Bills & Futures 1,110,083 1,010,333 910,583
Is Value in Strategy B > Strategy A? Yes Yes Yes
6_Arbitrage
Using Stock Index Futures for Speculation
Stock Index Futures can also be used for Speculation. (Risk arise due to absence of position in the Spot Market)
Speculator can take a view on the market by buying or selling Futures.
If the Speculator is BULLISH on the market, BUY the Futures
If the Speculator is BEARISH on the market, SELL the Futures
Consider an investor with Rs. 10 Lacs to invest.
Spot price of NIFTY is at 6500 and 3-month Futures is priced at 6650. (Contract Size=50x)
Margin requirement is 20%.
The investor expects the market to go up (by atleast 10%)over the next 3 months.
He can buy a balanced portfolio for Rs 10 Lacs in the Cash Market,
which shall appreciateby 10% if market goes up or decline by 5% if market goes down.
Instead of buying the Stocks, investor can buy the Futures on NIFTY.
NOW: Buy 3-month NIFTY Futures
Current Value of 3-month NIFTY Futures 6650
Contract Size 50
Value of 1 Futures Contract 332500
Initial Margin Required 66500 <-- =20%*G23
No. of Futures Contracts 15.0000 <-- =ROUND(1000000/G24,0)
Amount Invested 997,500
Cash Balance 2,500
LATER: Sell NIFTY Futures 10% Increase 5% Decrease
Current Value of 3-month NIFTY Futures 7,150 6,175
Profit/(Loss) of Futures:
Sell 7,150 6,175
Buy 6,650 6,650
Profit/(Loss) 500 (475)
Index Multiplier 50 50
No. of Contracts 15 15
Profit/(Loss) on Index 375,000 (356,250)
Return 37.59% -35.71%
7_Speculation
A trader anticipates a rally in the market.
He can simply be long on an Index Futures.
He, however, feels that Index A will advance more rapidly than Index B.
With differential responses, a CONSERVATIVE speculation position
strategy could be to use a Spread between the 2 Indices.
NOW: Buy Index Futures which is expected to move fast and Sell Index which is expected to move slowly.
LATER: Offset both the positions.
No. Index
1-Jan Buy MARCH Futures on Index A 15 4550.000 1 Futures on Index A 22750
Sell MARCH Futures on Index B 1 1250.000 1 Futures on Index B 312500
Index B/Index A 13.74
1-Feb Sell MARCH Futures on Index A 15 4750.000 4.40%
Buy MARCH Futures on Index B 1 1275.000 2.00%
Profit/(Loss) on Intra Market Spread: Index A Index B
Sell 4750.000 1250.000
Buy 4550.000 1275.000
Profit/(Loss) 200.000 -25.000
Index Multiplier 5 250
No. of Contracts 15 1
Profit/(Loss) on Index Rs. 15,000.00 Rs. -6,250.00
Total Profit/(Loss) on Spread Rs. 8,750.00
Inter Market Spread strategy
8_InterMarket Spread
A trader anticipates a rally in the market.
NOW: Buy farther Index Futures which is expected to move more and
Sell Nearby Index which is expected to move less.
LATER: Offset both the positions.
No. Index
1-Jan Buy MARCH Futures on Index A 1 4550.000
Sell FEB Futures on Index A 1 4495.000
28-Jan Sell MARCH Futures on Index A 1 4800.000 5.49%
Buy FEB Futures on Index A 1 4560.000 1.45%
Profit/(Loss) on Inter Market Spread: MARCH Index FEB Index
Sell 4800.000 4495.000
Buy 4550.000 4560.000
Profit/(Loss) 250.000 -65.000
Index Multiplier 250 250
No. of Contracts 1 1
Profit/(Loss) on Index Rs. 62,500.00 Rs. -16,250.00
Total Profit/(Loss) on Spread
Intra Market Spread strategy
Rs. 46,250.00
Sometimes, contracts farther from expiration respond differntly to
nearby contracts.The trader may use this by entering into a
CONSERVATIVE speculation Intra-Market spread.
9_Intra Market Spread