BY: Prof.

Kapil bhopatkar

Future strategies Session 5

Introductory Statement
 The market comprises of various participants
who differ in style, size(as regards their
capital), risk appetite but have a common aim
of maximizing return while at the same time
minimizing risk.
Hedger
 A hedger holds a position in the cash market
and wants to insure himself against adverse
price movement. He is worried that the value
of his portfolio may fall.
 He takes an opposite position in the futures

market .
 Implication????
Speculator
 They make estimates about the future prices
of stocks, indices and undertake buy or sell
transactions .
 While doing so he accepts the risk passed on

by the hedger.
 They provide depth and liquidity to the

market and without them the protection to

the hedger would prove very costly.
Spreaders
 They work on spreads that are supposed to
be non aligned and beyond their normal
difference.
Inter spread- intra spread
 In inter spread spreaders trade on two
different futures within the same contract
period as they believe that the prices do not
exhibit “normal difference”.

 Buy on one and sell on the other.

Intra spread
 A future bought expiring in the current
period and sell future contract in the
succeeding period.
Arbitrageurs
 Try to identify deviations in futures price
from their theoretical values in order to earn
a fair rate of return.
 It is not free and not completely devoid of

risk.
 It involves transaction costs, brokerage costs,

Impact costs.
 They have limited capital and credit lines.
 Every additional costs kills their motives and

profits and in turn and hurts volumes.

Scalpers
 They indulge in large number of quick trades
to make small profits by holding position for
minutes with total disregard to fundamental
or even technical analysis.
 They prefer those counters wherein the

volumes are high where transaction costs are

low.
 Their only benchmark is the price movement

and momentum.
Day Traders
 They enter into futures position and liquidate
their positions by the end of the day.
 They base their trades on proprietary model.
 More far sighted then scalpers ensuring they

don't have any overnight position.

 They depend on technical analysis, grapevine

and contribute to good liquidity in the

market.
Position traders
 Maintain position longer than a day until they
see a significant movement takes place.

 This period could be weeks or even months.

Future Trading strategies
Sell index futures to hedge portfolio
 Hedging is the act done to eliminate the risk
in the investment portfolio.
 It does not aim at maximizing profit or

minimizing risk. What it aims at is to lock the

investment at a Current Value.
 Benefit is that we dot loose and loss is that

we don’t gain
 Buy Cash Sell Futures or
 Buy Futures Sell Cash
 The basic hedging strategy is to take equal
and opposite position in the futures market
to the spot market.
Concept Hedge Ratio:-
 Why do we need a hedge ratio?
 It allows the hedger to decide the number of
future contracts that must be employed to
minimize the risk of combined cash futures
position.
Formula

 Hedge Ratio= Futures Position/Underlying

Asset Position
Example 6.1

 Assume that your portfolio of shares that

approximately in line with the S&P CNX Nifty
Index.
 On July 1 the value of the portfolio is worth

Rs 25 lakhs.
 You are concerned that the share market will

decline and want to lock the value of the

portfolio.
CoNTD
 The Index stands at 2050 points and Index
futures are trading at 2080 points. You sell
six contracts at 2080 points
 Assume that the start of September the Nifty

has fallen to 1870 points and the value of

your portfolio is down to Rs 22, 80,000/-
 The S&P index futures are trading at 1880

points . U close the position by buying six

Index futures contracts.
Cash Market Futures Markets

1st July 1st July

S&PCNX NIFTY INDEX- 2050 points SELL 6 S&PCNX NIFTY @2080 POINTS
Value of the portfolio= 2500000/- 6X2080X200
1ST September 1st September

S&P CNX NIFTY INDEX-1870 points BUY 6 S&PCNXNIFTY INDEX

Share Portfolio-2280000 FUTURES@1880 POINTS
Notional Loss= 220000 6X1880X200=2256000
PROFIT= 240000
anALYSIS
 The loss on the share portfolio has been
offset by the profit on the futures
transaction.
 WHY???
 Over hedging
 Your share portfolio may not have moved

exactly in line with the S&P CNX INDEX

 The futures and the physical prices have

converged . When we opened the futures it

was trading at premium of 30 points when we
closed the futures it was trading at 10 points
premium.
Leveraging
 What would have been the implication had
the Nifty futures risen over this period?
 Mr X believes that the portfolio performance
since the day it was constructed has been
good. He has clocked a return of 16.22% over
a three month period. He decides to protect
his portfolio by using S&PCNXNIFTY.
 What points should he consider
Diversification in the portfolio
 If the portfolio is well diversified it is
advisable to use broad based index.
 If 60% to 70% of the total portfolio comprises

of two or three stocks then use the stock

futures. However you will be doing two or
three trades and so corresponding
transaction costs will be high.
 Contrarian Method: use index despite the fact
that two or three stocks make up for 60 to
70% of the stocks. So volatile movements in
the stock are offset by less volatile movement
in the broad based index.
2. Extent of hedging
 By executing the perfect hedge the market
risk gets eliminated but it will generate risk
free return as opposed to capital market
theory which states that investors are
rewarded for the market risk component in
their portfolios.

 But why is the perfect hedge impossible?

 The success of any hedging strategy depends
in part upon how closely movements in the
value of the shares being hedged track
movements in the index underlying the
futures contract.
 This is often known as the “Basis Risk”
Amount of hedge
 Choosing between slightly over hedging or
under hedging.
 Hedged and hedging positions differ in terms

of
 A) The time span covered
 B)Amount of the asset
 C)Particular characteristics of Goods
Deciding the hedge ratio:
 Hedge Ratio=Futures position/Cash Market
position
Correlation between Beta and hedge
ratio
 Beta of the stock
 The index is against which it is measured.
Hedging Process
 Nifty is quoting at 2189.05 . Lots size 200
contracts . Weighted average size of the beta
= .98. Market Value of the portfolio 1767.59
X100000
 Portfolio of MR.X
Portfolio Beta Each Nifty Extent of Number of
Value Contract hedging Contracts

Rs 1767.59 0.98 Rs 437810 100% 396

Rs 1767.59 0.98 Rs 437810 50% 198

Rs 1767.59 0.98 Rs 437810 20% 79

Post hedging analysis
Market up by 1767.59*1.1=19 397x = (1944.35-
10% 44.35 lakhs 200x2189.05x1. 1767.59) –
1=1911.92 (1911.92-
lakhs 1738)=2.845
lakhs

Market down by 1767.59*0.9=15 397x200x2189. =(1590.83 –

10% 90.83 lakhs 05x0.9=1564.3 1767.59) –
0 lakhs (1564.30
--1738)=
--3.06 lakhs
Tailing the hedge
 The Mark to Market margin results in daily
payments and receipts of floating profit /loss
on futures position.
 As the cash and the futures markets tend to

move in tandem there is an underlying

change in the value of the portfolio.
 But that Profit/ loss is unrealized and will

become actual loss only when the portfolio is

liquidated.
 It is therefore required to make adjustments
for this differential treatment of floating
profit/ loss in the number of futures that we
need to buy and sell everyday to make it
perfect hedge.
 This procedure is known as tailing the hedge.
Sources of Errors
 Basis Risk
 It is the imperfection in hedge arising out of the

standardized amount of in futures market and

the changing cost of carry.
 Due to standardization effect tailing should be

adjusted daily but this is rarely done.

 Changes in cost of carry means that premium to

which the futures are trading may change.

 This will affect the hedge if the period of
hedge is different from the expiry date.
 Tracking error refers to the change in beta

between the portfolio and the index futures.

 Conversion of price risk into basis risk which
is less risky????

 EXPLAIN KARR…
Sell stock futures against a fall in
current holdings
 If the stock is fundamentally strong and has
long term prospects it is not advisable to sell
it due to short term volatility.
 In such cases it is advisable to sell the stock

futures to hedge against adverse price

movements.
Buy Futures
 Buying futures ensures that funds are liquid
while the opportunity to participate in the
potential rally also exists.
 For eg
 Prof. B has 10 crores to invests. He is also

expecting the blue chip stocks to appreciate.

 He will buy futures and participate in the

rally. By this time he will be ready with the

stock selection.
 He has gained in two ways. He has
participated in the rally and also he has
blocked only 90% of his funds which can be
used to invest in short term money market
investments.
 Even when the market falls he can buy the

blue chip stocks at a cheaper price and the

loss can be covered at least partially by the
return on investments on money market
instruments.
SPECULATE
 Taking position in the futures market without
having the underlying cash.
 Naked Position: Position in any futures
contract
 Spread Position: Opposite positions in two

futures contracts also known as conservative

speculation strategy.
 Bring liquidity
 Price discovery
 Leveraging
Arbitrage:
 buy in one market sell in another

 Eg
 Cash and Futures
 Two different Futures Markets
 Two different Cash Markets
 Risk free returns which are better then
savings deposit rates and other risk free
liquid assets.

 Eg: Cash Futures

Reliance (DOE) 650 656

Expiry date 680 680

COC during Dividend Season:
 Cost of Carry should always be a positive figure
except during the dividend season. But in an
oversold market we shall observe that the
futures prices are lower then the spot market.
 That is because the market is cash settled and

not delivery settled and hence the futures price

represents only the sentiment rather than the
financing costs.
Quants
 Reliance cash price is 626/- futures price
600/-. Settlement Price 650/-
 Assume that you buy back the stock at the

loss of Rs 24 and make Rs 50 on the

settlement of the futures position.
 Have u calculated interest on the borrowed

stocks?
 What about Margins and Commissions.?

What are the implications?

 Futures prices reflects the absence of
dividend amount in their price.
 Futures prices correct more than the dividend

amounts due to market inefficiencies.

 This mispricing is used by arbitrageurs

during the dividend season.

Eg:
 In 2004 when Bajaj declared a dividend of Rs
25/- and ex dividend date was July 15 2004
the futures price was quoting at 864/- 34 Rs
less than the Cash Price .
 You will observe that the actual difference is

more than the dividend difference even after

taking into account the cost of carry.
 How does an investor take advantage of this
inefficiency?
solutions
 Sell cash buy futures
 The return will be higher than the dividend

yield of the stock.

 Nifty July Discount Div Addl.
Close Futures Discount Discount
Nifty 2114.15 2104.4 9.75 7.71 2.04
stoCK aRBITRAGE
 SELL THE STOCK IN THE CASH MARKET AND
BUY THE FUTURES.
Basket Trading
 Basket trading is the trading of a group of
securities in a single order. Typically, these
securities are put together in order to achieve
a specific investment goal. In order to be
eligible to basket trade, investors are usually
required to purchase a minimum number of
securities. While this minimum is often set at
ten or 15, it will vary based on the
requirements of the brokerage service
facilitating the basket transaction.
BASKET Trading
Basket trading is a commonly-used investment
strategy among program traders, hedge funds and
large institutional investors who have significant
amounts of money to invest.
 Small investors may also use basket trading as a

method for mitigating risk because it can help

diversify the stocks in an investment portfolio to a
variety of different sectors. Basket trading stocks are
one of the most standard types of basket trades.
Other frequently traded securities include currencies,
futures and similar financial instruments.
Pairs TRading
 One stock underperforming 0ne stock
0verperforming in the same sector.
 If one buys an underperforming company in

the futures market while simultaneously

selling the outperforming stock in the futures
market and squaring it off after one feels
that the mispricing ceases to exist, one
makes a riskless profit. This strategy is
known as “Pairs Trading”
Pairs Trading can Fail if

 The volume is not enough to cover the

positions.
 Beta Adjustments are not made in the correct

manner.
 Wrong stocks are chosen.
Benefits
 Multiple trades in just one order, allowing investors and
traders to be more efficient in managing their securities.
 Provide investors with the ability to tailor their investment

portfolios to their specific needs and goals. For example,

investors can arrange their baskets by a range of categories
such as price, market capitalization, goals, or industry/sector.
 Maintaining a high level of control over trading portfolios . An

investor has the option of trading selected individual

securities within a single basket or trading the entire basket.
This function allows an investor to control the timing of any
trades that he or she conducts.
 In addition, it allows the investor to monitor any tax

implications that may be associated with basket transactions.

Using futures to modify systematic
Risk.
 Assume that the manager has a portfolio of
Rs 10million with a Beta of 1 and wants to
move the Beta to 1.2. Assume that the
portfolio is 80% stock and 20% cash.
 Suggest how can he move the Beta from 1 to

1.2
Impediments in suggestions
 Lengthy process
 Transaction Costs.
 All higher Beta stocks may not possess the

same investment characteristics

 Portfolio manager may end up with the wrong

stocks in his portfolio.

Using futures for beta
modifications
 Suppose the Nifty is trading at 2150 and
futures is quoting 2165. Then the fund
managers can buy index futures in such a
way that the following equation is satisfied.
 8000000 * 1.0 +2165 * 200 *N=

10000000*1.2
 Calculate N
 N= 9
 Thus the fund manager will have to buy 9

contracts in order to achieve a higher Beta.

 Incase he wants to lower the Beta ????
THaNK YOU!!!!