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13 November 2008

HEDGE : NOT A FOUR LETTER WORD

Hedge is not a four letter word.

Numerically I may be correct. Five. But in the world of investments? I am not too sure. Everyday, the global financial market meltdown throws up a new villain of the piece.Subprime and leverage in the first half were followed by greedy investment bankers and unscrupulous rating agencies. They all contributed to the downslide resulting in a flight of capital to safety. Especially so in the emerging markets where one often heard of another scoundrel - the fleet footed hedge fund manager selling out , resulting in a free fall of stock prices.

What do hedge funds do? I dont know. But I do know what a 'hedge' is.

Say you have a portfolio of Rs 1,110,000 , with Rs 900,000 in equity and the rest in cash. Having invested in the market in end 2007 you do not find it prudent to book your losses and move to cash. A part of you believes in the India story and the quality of the stocks you are holding. Hence you are prepared to stick it out for the next two years or so. This market strategy is for you.

Say your equity portfolio has a beta of 1 and the Nifty is at 3000. Over the next two weeks, the nifty grinds down to 2700. Your portfolio is now worth Rs 810,000 plus Rs210,000 i.e. Rs 1,020,000. Your decision dilemma is - should I sell or buy more to average out? At the moment I say - neither. Hedge it.

To hedge Rs 900,000 of equity portfolio, we require Rs 900,000 in futures. i.e. 6 lots of Nifty Futures of Rs 150,000 each. If you short these 6 lots at Nifty 3000, your total margin requirement is approximately Rs 210,000. So that is where you deploy your surplus cash. So in the event the Nifty tanks to 2700, your equity portfolio would be worth Rs 810,000 while 6 lots of 50 Nifty each will fetch you Rs 90,000 (6 x 50 x 300). No profit, no loss. despite a 10% fall in market. Now thats a simple hegde!

I wish life and investing were so simple. For starters your portfolio beta may not be 1. Say it is 1.25. So short 7 lots instead of six. But the real question is - what if the market moves up? 

Say the market moves up five percent from 3000 in one day. Your mark to market losses would be 150x50x6 = 4500. The same amount that your portfolio would gain. So what is the fun investing if the portfolio is going to work like a Not-For-Profit organisation? That fun can be introduced by keeping a stop loss, say at 3% above the market price. So the downside is fully protected but the cost is - a small fall in profit. In the current market conditions, that is a small price to pay.

Another variation to the strategy - if over a period of time the equity portfolio value falls substanitally ( and that seems to be the case for most of us!) and you find yourself overhedged, book your profit in a lot or two and use the cash to buy your favourite stock. 

Well I guess 'Hedge' is not a four letter word after all!

PS :- a word of caution - KISS.

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