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Using index futures: A case for hedging - IV

Kshama Fernandes

Have you ever been in a position where you anticipate a substantial cash inflow in the near future, part of which you would like to invest in equity? Let's continue with the case of my father who upon retirement was to receive a lumpsum, part of which he planned to invest into equity. A couple of months before he retired he knew approximately how much money he would receive upon retirement.

Assume the Nifty at that point was reigning at 1400. But by the time he actually got his retirement proceeds in his hand, the market had moved up to 1500. Clearly, he had lost due to a rise in the Nifty.

Or perhaps, you have plans to enter into a deal for sale of land and would like to invest the proceeds into equity because you believe that at the moment, the Nifty is unusually cheap. As we all know, land sale is a rather slow and tiresome process and it could be some time before you actually got the money in hand for investment. All the while you are exposed to the risk of the market rising.

Or take the case of a mutual fund which has just sold fresh units and has received funds. Investing the entire amount into the equity market overnight may not be an advisable option for a number of reasons. For one, the fund managers may need time to research stocks and decide what stocks to buy. This takes time and all the while the fund is holding cash. If the market moves up by the time the fund gets down to buying equity, clearly the fund has missed out on the opportunity of buying at lower levels.

Secondly, even assuming that the fund manager knows the portfolio he would like to build, buying the required quantity of a given stock using market orders would undoubtedly generate high impact costs. The ideal thing to do in the circumstances would be to place limit orders and gradually buy the required portfolio. But once again, during the time it would take him to acquire the desired portfolio, he would be exposed to the risk of losing out if the market rises.

Faced with situations like the ones described above, how would one hedge against an upward movement in the market? Staying in cash when one would like to invest into equity is risky. A person desiring to invest in stocks is as vulnerable to an upward movement in Nifty as a person holding stocks is vulnerable to a downward movement of the index. So what is the way out?

It simply involves obtaining the desired equity exposure by buying index futures. A person who expects to obtain Rs 2 million by selling land would have to immediately enter into a position Long S&P CNX Nifty worth Rs 2 million. Futures markets being more liquid, it is possible to take large positions at very low impact costs. Subsequently, the person could gradually acquire his desired portfolio and correspondingly unwind his futures position.

Take for instance the case of a closed-end mutual fund. Money would typically trickle in over a week. Instead of rushing into buying spot, at the end of each day to the extent of funds coming in, the fund should build a long position on the index futures market. This way the fund has enough time to conduct research for stock selection.

Since there is no immediate hurry to acquire shares, instead of placing market orders, the fund could now try placing aggressive limit orders. As and when these orders go through, the futures position could be unwound. This strategy would fully capture any rise in the market with no risk of missing out on a rise in the stock market while this process of buying stock and unwinding futures took place.

The crucial point to be understood here is that holding cash when you want to be invested in equity is risky. It is as important for an owner of shares to hedge against a drop in Nifty as it is for the holder of cash to hedge against a rise in the Nifty. Index futures can be beautifully used for hedging in both scenarios.

The author is a faculty member at the Department of Management Studies, Goa University. She handles capital markets and derivatives.

Derivatives Center

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