Hedging
We earlier discussed hedging using futures contracts in the context of a business protecting the value of its inventory. We now discuss some hedging strategies available to portfolio managers based on financial futures. Essentially, an investment portfolio is an inventory of financial securities, and futures can be used to reduce the risk of holding a securities portfolio.
We consider the specific problem of an equity portfolio manager wishing to protect the value of a stock portfolio from the risk of an adverse movement of the overall stock market. Here, the portfolio manager wishes to establish a short hedge position to reduce risk and must determine the number of futures contracts required to properly hedge a portfolio.
In this hedging example, you are responsible for managing a broadly diversified stock portfolio with a current value of $100 million. Analysis of market conditions leads you to believe that the stock market is unusually susceptible to a price decline during the next few months. Of course, nothing is certain regarding stock market fluctuations, but still you are sufficiently concerned to believe that action is required.
A fundamental problem exists for you, however, in that there is no futures contract that exactly matches your particular portfolio. As a result, you decide to protect your stock portfolio from a fall in value caused by a falling stock market using stock index futures. This is an example of a cross-hedge, where a futures contract on a related, but not identical, commodity or financial instrument is used to hedge a particular spot position.
Thus, to hedge your portfolio, you wish to establish a short hedge using stock index futures.
To do this, you need to know how many index futures contracts are required to form an effective hedge. There are three basic inputs needed to calculate the number of stock index futures contracts required to hedge a stock portfolio:
The current value of your stock portfolio,
The beta of your stock portfolio,
The contract value of the index futures contract used for hedging.
You should be familiar with the concept of beta as a measure of market risk for a stock portfolio. Essentially, beta measures portfolio risk relative to the overall stock market. We will assume that you have maintained a beta of 1.25 for your $100 million stock portfolio.
You decide to establish a short hedge using futures contracts on the Standard and Poor’s index of 500 stocks (S&P 500), since this is the index you used to calculate the beta for your portfolio. From the Wall Street Journal, you find that the S&P 500 futures price for three-month maturity contracts is currently, say, 1,300. Since the contract size for S&P 500 futures is 250 times the index, the current value of a single index futures contract is $250 × 1,300 = $325,000.
You now have all inputs required to calculate the number of contracts needed to hedge your stock portfolio.
