B.K.

SCHOOL OF PROFESSIONAL AND MANAGEMENT STUDIES

Gujarat University

PROJECT REPORT

“Hedging Stock Portfolio Using Stock Beta and Options”

Semester – 2, Division –A

Batch: 2019 - 2021

Submitted to

Dr Nilam Panchal

Submitted by
Miral Patel
Roll no - 119060
 Declaration

I Miral Patel student of B.K School of Professional and Management studies

the solemnly declare that the SIP report “Hedging Stock Portfolio Using
Stock Beta and Options” based on my own work carried out during the course
of our study under the supervision of Dr Neelam Panchal . I assert the
statements made and conclusions drawn are an outcome of my research work.
The work contained in the report is original and has been done by me under the
general supervision of my supervisor. The work has not been submitted to any
other Institution for any other degree/diploma/certificate in this university or
any other University of India or abroad.

Name: Miral Patel

Roll No: 119060

Company Profile:

Incorporated in 2004, Prudent Broking Services Pvt Ltd is a Stock Broking and
Depository Participant service provider. Company is a member with Bombay
Stock Exchange (BSE), National Stock Exchange (NSE), Metropolitan Stock
Exchange (MSEI), Multi Commodity Exchange of India Ltd. (MCX) and
National Commodity & Derivatives Exchange Limited (NCDEX) & Central
Depository Services (India) Limited (CDSL).

Products of the company:

1. PRUALPHA

      PRUALPHA is a long only strategy where

  Entry and exit will be purely based on technical analysis; (i.e. study of
charts)
  It is a delivery-based product; (i.e. no derivative/leveraged position)
 The stock will be selected based on the predefined technical indicators.
Broadly the stock which are in overall uptrend and are breaking out are a
consolidation phase, will be considered
  The stocks having average 20-day volume of 2 lac or more will be
considered
 Typical holding period for a stock will be around 15-20 sessions. The
holding period might reduce / go up if the target is achieved / stop-loss is
hit earlier / later.
 Typically, the stop-loss level would be in the region of 5-10% which will
be considered on closing basis while target would be in 7-15% range
 Each stock will be allocated 7.5% of total corpus

2. PRUGROW
  Pro-Growth-Money-Management
 An Investment Strategy That Gives the Best Of Both Worlds
  PRUGROW works on a unique strategy, which combines both
fundamental and technical analysis to generate superior return compared
to index.
 The idea is to select a “fundamentally sound stock” which is also
technically bullish i.e. looking strong on chart. Better known as
TECHNO FUNDA calls.

3. WISHBASKET
 WISHBASKET is a pre-researched portfolio of stocks with weights
assigned to each stock in the portfolio. The basket could be based on an
idea, theme or strategy.
 It is conceptualized to solve two key problems of investors…

I. Which stock to buy?

II. What should be the weightage of that stock in the overall portfolio?

 Investors receive advice from different sources like Relationship

Managers, Friends, Brokerage Research Reports, Neighbours, and
Television Anchors etc. This creates bigger confusion on what to buy or
not to buy.
 The research team at WishBasket not only helps you to find the best
quality stocks, they also determine the appropriate weightages to be
assigned to each stock. The combination of both these factors helps
investors to manage risks while generating returns.

4. PRUIDEA 

PRUIDEA is a fundamental product recommending stocks with a long-term

view.

Process to select Stocks in PRUIDEA.

 Reading Annual Reports.

 Listening to Conference Calls of Management post reporting of Quarterly
Results.
 Doing Channel Checks by Inquiring through Dealers and Distributors.
 Analysing Free Cash Flows & Performance over Different Cycles.
 Analysing the Competitors & Threats.
 Referring to Industry Research Reports.
 Making Financial Models for Future Projections.
  Deriving at Target Price using Relevant Valuation Techniques.

Table of Content

Sr No. Title Page No

1 Abstract 4

2 Literature Review 5

3 Introduction 7

9 Research Methodology 9

Objective

Type of Research

Data collection

5 Data Analysis and Interpretation 10

6 Scope and Limitations of Studies 31

7 Conclusion 31

8 Bibliography 32
 Abstract

This report is titled “Study on Hedging Portfolio using stock Beta and Options”.
Any investment portfolio is vulnerable to a range of different risks. No one
knows for sure if, or when, there may be a market crash coming, but we can
reduce risk with portfolio hedging using Futures and Options.

A hedge is a strategy that mitigates against the risks to an investment. In many

cases a hedge is an instrument or strategy that appreciates in value when your
portfolio loses value. The profit on the hedge therefore offsets some or all of the
losses to the portfolio.

There are several different risks that can be hedged. Moreover, there are
numerous strategies to hedge these risks. Some portfolio hedging strategies
offset specific risks, while others offset a range of risks. In this research we are
focusing on hedging stock portfolios against various risk.
 Literature Review

Prof. Rekha D. M | Lavanya The aim of the article is to identify the

major risk and hedging strategy in derivative market. In Derivative Contracts
as a high risk that are Market risk, Liquidity risk, Credit risk, Counterparty risk,
Legal risk and Transaction Risk. pricing risk and systematic risk is also very
important. Derivative investor must analyze the market and make the decisions
while trading this will undergoes the uncertainty. Derivatives plays a major role
for minimizing the risk involved in the marking an investment in futures
contracts by expecting to get good result. The investors should also invest in
options contracts which help to reduce the risk by use of hedging strategy.
Hedging strategy is used for reducing the risk and maximization of profits.
Though the futures contracts are subjected to high level the loss can be reduced
to an extent by using the hedging strategy

Diskshista Wadhawan and Harjit Singh (2015): Options are financial

derivatives which are used as risk management tools for hedging the portfolios.
The options traders can play safe in the volatile markets with the help of
knowledge of the Greeks associated with the options. This study is focussed at
providing the knowledge of the Greeks and their implementation as risk
management tools so as to enhance gains or avoid losses. Delta, Vega and Theta
of the options as well as the other position Greeks are associated with the any
option strategy and they equally impact the portfolio. The knowledge of impact
of Greeks on different strategies will lead to determine how much risk and
potential reward is associated with the portfolio. The study will focus on getting
instrument rated with options trading perspective, in order to make investor
handle any strategy scenario and hedge the risk so as to gain good rewards. This
will also guide the investor to determine the risk reward ratio, prior to entry in
the trade. Options trading can be taken to next level with the help of
understanding of Greeks and their Hedging techniques. This knowledge will
enhance the existing knowledge in context to the options hedging and will lead
to the benefits in trading if Delta-Gamma neutralised strategy or Delta-Vega
neutralised strategy will be employed along with the best market movement
suited option strategy.

sharma and Sahi (2007) focus on investors perception regarding the financial
derivatives especially futures and options and the various risk hedging
strategies. An attempt has been made to check the extent of awareness of these
new instrument used in the securities market. The sampling technique used was
non probabilistic convenience sampling techniques. In order to analyse the data
collected the statistical tools like factor Chapter 2 - Literature Review 57
analysis and Chi-square were used. Apart from this weighted average score is
also being used for analysis.
Srivastava (1998) in his study examines the cases in real life with the aim of
providing a detailed insight into the fact that if derivatives are not properly used
they may lead to disaster. In this study an attempt has been made to analyse the
various issues relating to financial derivatives in the global context. The study
points out three main reasons why stock index futures are mostly preferred: a)
Institutional and other large equity holders think in terms of portfolio hedging
b)These are the most cost efficient hedging device, and c) Stock index cannot be
easily manipulated where as individual stock price is manipulated easily
jyothi (2006) strongly argues that India as compared to other markets is still in
developing stage. Volume traded is increasing in a slow pace. All trading
process is regulated. The study also points out that there is a lack of knowledge
about hedging.
Fazal M. Mahomed (2017) The results emphasize the need for combining
futures hedging and options hedging, and it also shows that imposing
background risk, whether it be additive or multiplicative, always has a great
impact on the hedging efficiency. We also present some sensitivities of the
relevant parameters to provide some suggestions for the investors
 Introduction

Portfolio hedging is a form of insurance to protect your portfolio from a deep

draw-down in the event of a steep market fall.  When an investors decide to
hedge, they are insuring themselves against a negative event's impact to their
finances. This doesn't prevent all negative events from happening, but
something does happen and you're properly hedged, the impact of the event is
reduced. Portfolio managers, individual investors, and corporations use hedging
techniques to reduce their exposure to various risks. In financial markets,
however, hedging is not as simple as paying an insurance company a fee every
year for coverage.

When you buy the stock of a company you are essentially exposed to risk. In
fact there are two types of risk – Systematic Risk and Unsystematic Risk. When
you buy a stock or a stock future, you are automatically exposed to both these
risks.
Systematic risk, also known as market risk, cannot be reduced by diversification
within the stock market. Sources of systematic risk include: inflation, interest
rates, war, recessions, currency changes, market crashes and downturns plus
recessions. Because the stock market is unpredictable, systematic risk always
exists. Systematic risk is largely due to changes in macroeconomics. 
Unsystematic risk, also known as company-specific risk, specific risk,
diversifiable risk, Declining revenue, Declining profit margins, Higher
financing cost, High leverage, Management misconduct, represents risks of a
specific corporation, such as management, sales, market share, product recalls,
labour disputes, and name recognition. This type of risk is peculiar to an asset, a
risk that can be eliminated by diversification.
Hedging strategies typically involve derivatives, such as options and futures
contracts. An Option is a contract that gives the right, but not an obligation, to
buy or sell the underlying asset on or before a stated date/day, at a stated price,
for a price. The party taking a long position i.e. buying the option is called
buyer/ holder of the option and the party taking a short position i.e. selling the
option is called the seller/ writer of the option.
The option buyer has the right but no obligation with regards to buying or
selling the underlying asset, while the option writer has the obligation in the
contract. Therefore, option buyer/ holder will exercise his option only when the
situation is favourable to him, but, when he decides to exercise, option writer
would be legally bound to honour the contract.
Options may be categorized into two main type
 Call Options
 Put Options
Option, which gives buyer a right to buy the underlying asset, is called Call
option and the option which gives buyer a right to sell the underlying asset, is
called Put option.
Futures are derivative financial contracts that obligate the parties to transact an
asset at a predetermined future date and price. Here, the buyer must purchase or
the seller must sell the underlying asset at the set price, regardless of the
current market price at the expiration date
There is no sure way to choose the best available options when hedging stocks.
You can, however, consider the pros and cons of the available options and make
an informed choice. You will need to consider several factors when considering
your alternatives. The first decision will be to decide how much of the portfolio
to hedge. If you are hedging an equity portfolio that forms part of a diversified
portfolio, your entire portfolio is already hedged to an extent. In that case a
smaller hedge would be required.
 Research Methodology
Objective
1. To curtail potential loss due to sudden market fall.
2. To show how Futures and Options can be used as risk management tool
to hedge portfolio.
3. To analyse and present different hedging strategies.

Type of Research Used

1) Qualitative Research
Qualitative Research generates non-numerical data. It focuses on gathering data
mainly verbal data rather than measurements. In this project qualitative data is
collected by studying various research paper, journals, articles and report on
hedging portfolio, types of risk involved in financial market, Optimal hedging
using Futures and options etc.
2) Quantitate Research
Quantitative research is a research method that is used to generate numerical
data and hard facts, by employing statistical, logical and mathematical
technique. Statistical data for the study was collected from the web portals and
reports of NSE and BSE. For extensive research various published sources like
online journals, research thesis, dissertations and various online websites were
used.

Data Collection
Data for the study is purely based on secondary sources such as research paper,
journals , Articles and also internet.
 Data Analysis and Interpretation
One of the most important and practical applications of Futures and Options is
‘Hedging’. In the event of any adverse market movements, hedging is a simple
work around to protect your portfolio from making a loss.
Hedge - but why?
A common question that gets asked frequently when one discusses about
hedging is why really hedge a stock portfolio? Imagine A trader or an investor
has a stock which he has purchased at Rs.100 before COVID-19 Pandemic.
Now he feels the market is likely to decline due to pandemic blooming over
financial market and so his stock will also decline. Given this, he can choose to
do one of the following

1. Take no action and let his stock decline with a hope it will eventually
bounce back after pandemic is over
2. Sell the stock and hope to buy it back later at a lower price
3. Hedge the position

Firstly let us understand what really happens when the trader decides not to
hedge. Imagine the stock you invested declines from Rs.100 to let us say
Rs.75. We will also assume eventually as time passes by the stock will
bounce back to Rs.100. So the point here is when the stock eventually moves
back to its original price, why should one really hedge?
Well, you would agree the drop from Rs.100/- to Rs.75/- is a 25% drop.
However when the stock has to move back from Rs.75/- to Rs.100/- it is no
longer a scale back of 25% instead it works out to that the stock has to move
by 33.33% to reach the original investment value. This means when the
stock drops it takes less effort do to so, but it requires extra efforts to scale
back to the original value. Hence for this reason, whenever one anticipates a
reasonably massive adverse movement in the market, it is always prudent to
hedge the positions.
But what about the 2nd option ? Well, the 2nd option where the investor sells
the position and buys back the same at a later stage requires to time the
market, which is not something easy to do. Besides when the trader transacts
frequently, he will also not get the benefit of Long term capital tax. Needless
to say, frequent transaction also incurs additional transactional fees.
 For all these reasons, hedging makes sense. It is like taking vaccine shot
against a virus. Hence when the investor hedges he can be rest assured the
adverse movement in the market will not affect his portfolio.
 Hedging a single stock position
Hedging a single stock future is relatively simple and straight forward to
implement. In order to hedge the position in spot, we simply have to enter a
counter position in the futures market. Since the position in the spot is
‘long’, we have to ‘short’ in the futures market.
Lets us consider an example suppose you bought 100 shares of Maruti
Suzuki Shares at 6800 per share. This works out to an investment of
Rs.680,000/-. Clearly you are ‘Long’ on Maruti Suzuki in the spot market.
After few days the fear of corona-virus start blooming over financial market.
You are worried that Market may start declining along with Maruti Suzuki
also so as a result of which the stock price may decline considerably. To
avoid making a loss in the spot market you decide to hedge the position . In
order to hedge the position in spot, we simply have to enter a counter
position in the futures market. Since the position in the spot is ‘long’, we
have to ‘short’ in the futures market.
Here are the short futures trade details –
Short Futures @ 6800
Lot size = 100
Contract Value =680000
Now on one hand you are long on Maruti Suzuki (in spot market) and on the
other hand you are short on Maruti Suzuki (in futures price), although at
different prices. However the variation in price is not of concern as directionally
we are ‘neutral’
After initiating this trade let us arbitrarily imagine different price points for
Maruti suzuki and see what will be the overall impact on the positions.
 Bought Price DATE Closing price Long Spot P&L Short Future P&L Net P&L
6800 20-Feb-20 6757.6 -42.4 42.4 0
6800 24-Feb-20 6470.4 -329.6 329.6 0
6800 25-Feb-20 6414.55 -385.45 385.45 0
6800 26-Feb-20 6234.85 -565.15 565.15 0
6800 27-Feb-20 6289.8 -510.2 510.2 0
6800 28-Feb-20 6283.1 -516.9 516.9 0
6800 2-Mar-20 6285.15 -514.85 514.85 0
6800 3-Mar-20 6386.05 -413.95 413.95 0

The point to note here is – irrespective of where the price is headed (whether it
increases or decreases) the position will neither make money nor lose money. It
is as if the overall position is frozen. In fact the position becomes indifferent to
the market, which is why we say when a position is hedged it stays ‘neutral’ to
the overall market condition. As I had mentioned earlier, hedging single stock
positions is very straight forward with no complications. We can use the stock’s
futures contract to hedge the position. But to use the stocks futures position one
must have the same number of shares as that of the lot size. If they vary, the
P&L will vary and position will no longer be perfectly hedged.
This leads to a few important questions –

1. What if I have a position in a stock that does not have a futures contract?
For example Karnataka Bank does not have a futures contract, does that
mean I cannot hedge a spot position in Karnataka Bank?
2. The example considered the spot position value was RS 680,000/-, but
what if I have relatively small positions – say Rs.50,000/- or Rs.100,000/-
is it possible to hedge such positions?
3. In fact the answer to both these questions is not really straight .For now
we will proceed to understand how we can hedge multiple spot positions
(usually a portfolio). In order to do so, we first need to understand
something called as “Beta” of a stock.
 Let us understand Beta

Beta in finance, represented by either the word or the Greek letter β, is a

term used to refer to the volatility of a particular investment, such as a
stock, meaning how it fluctuates compared to the market as a whole. It's
usually computed by comparing historic market fluctuations to something
that captures the whole market, such as the NIFTY50 or SENSEX Index
of Indian Markets.
A beta value of 1 indicates that a particular stock is exactly as volatile as
the index used for the comparison. A beta value between 0 and
1 indicates that the stock is less volatile than the market as a whole, and
a value greater than 1 indicates more volatility. A beta value
of 0 means the stock's performance is uncorrelated with the market.
You may also see beta values below 0, indicated with a negative sign.
This means that the stock has a tendency to move in the opposite
direction from the market as a whole.

In plain words Beta measures the sensitivity of the stock price with
respect to the changes in the market, which means it helps us answer
these kinds of questions –

1. If market moves up by 2% tomorrow, what is the likely movement in

stock XYZ?
2. How risky (or volatile) is stock XYZ compared to market indices (Nifty,
Sensex)?
3. How risky is stock XYZ compared to stock ABC?

The beta coefficient can be interpreted as follows:

β =1 exactly as volatile as the market

β >1 more volatile than the market
β <1>0 less volatile than the market
β =0 uncorrelated to the market
β <0 negatively correlated to the market
Calculating beta in MS Excel

1. Download the last 6 months daily close prices of Nifty and stocks in your
portfolio. You can get this from the NSE website

2. Calculate the daily return of both Nifty and stocks.

a. Daily return = [Today Closing price / Previous day closing price]-1

3. In a blank cell enter the slope function

a. Format for the slope function is =SLOPE (known_y’s, known_x’s),

where known_ y’s is the array of daily return of stock, and known_
x’s is the array of daily returns of Nifty.

Hedging a portfolio
Let us assume a stock portfolio of capital RS 25,00,000. Here the Investor has a
long term vision of say 5 years. This stock portfolio was made before Covid-19
Pandemic. Now he feels the market is likely to decline due to pandemic
blooming over financial market and so his stock portfolio will also decline.
Hence he think to hedge his portfolio. The thing here is to note that stocks in his
portfolio are not part of Derivatives (Futures and options). So he decides to
hedge using Stock beta.
As we know there are mainly 2 types of risk – systematic and unsystematic risk.
When we have a diversified portfolio we are naturally minimizing the
unsystematic risk. What is left after this is the systematic risk. As we know
systematic risk is the risk associated with the overall markets, hence the best
way to insulate against market risk is by employing an index which represents
the market. Hence the Nifty futures come as a natural choice to hedge the
systematic risk.
Sr no Stock Name Buying Price Investment
Amount
1 Aarti RS 840 RS 750,000
Industries
2 Crisil RS 1540 RS 625,000
3 Godfrey RS 960 RS 450,000
Phillip
4 Avanti Feed RS 560 RS 300,000
5 Karnataka RS 62 RS 375,000
Bank
 Beta Calculations of stocks in Excel Sheet

Aarti Industries Nifty 50

Date Closing Price Return BETA Date Closing price Return

1-Jan-19 1448.6 0.85 1-Jan-19 10910.1
2-Jan-19 1450.7 0.14% 2-Jan-19 10792.5 -1.08%
3-Jan-19 1429.15 -1.49% 3-Jan-19 10672.25 -1.11%
4-Jan-19 1463.35 2.39% 4-Jan-19 10727.35 0.52%
7-Jan-19 1471.8 0.58% 7-Jan-19 10771.8 0.41%
8-Jan-19 1494.1 1.52% 8-Jan-19 10802.15 0.28%
9-Jan-19 1494.65 0.04% 9-Jan-19 10855.15 0.49%

Here we have calculated the data in excel sheet of all stocks in portfolio. We
took data of 1 year from January 2019 to December 2019 to calculate Beta. The
data consist of closing price of individual stocks and closing price of Nifty50.
And then we have calculated the Return of individual stocks and Nifty50.

Beta of individual stocks in our Portfolio

Sr no Stock Name Stock Beta
1 Aarti Industries 0.85
2 Crisil 0.37
3 Godfrey Phillip 0.87
4 Avanti Feed 1.01
5 Karnataka Bank 1.23

Step 1 – Portfolio Beta

There are a few steps involved in hedging a stock portfolio. As the first step we
need to calculate the overall “Portfolio Beta”.

 Portfolio beta is the sum of the “weighted beta of each

stock”.
 Weighted beta is calculated by multiplying the individual
stock beta with its respective weightage in the portfolio
 Weightage of each stock in the portfolio is calculated by
dividing the sum invested in each stock by the total portfolio value
  Weightage of Aarti industries in portfolio = 750,000/25,00,000 = 30%
 Hence the weighted beta of Aarti Industries on the portfolio =
30*0.85/100 = 0.255

 Weightage of Crisil in portfolio = 625,000/25,00,000 = 25%

 Hence the weighted beta of Crisil on the portfolio = 25*0.37/100 = 0.092

 Weightage of Godfrey Phillip in portfolio = 450,000/25,00,000 = 18%

 Hence the weighted beta of Godfrey Phillip on the portfolio =
18*0.87/100 = 0.156

 Weightage of Avanti Feed in portfolio = 300,000/25,00,000 = 12%

 Hence the weighted beta of Avanti Feed on the portfolio = 12*1.01/100
= 0.121

 Weightage of Karnataka Bank in portfolio = 375,000/25,00,000 = 15%

 Hence the weighted beta of Karnataka on the portfolio = 15*1.27/100 =
0.190

Sr no Stock Name Beta Investment Weight in Weightage

Amount portfolio beta
1 Aarti 0.85 750,000 30% 0.255
Industries
2 Crisil 0.37 625,000 25% 0.092
3 Godfrey 0.87 450,000 18% 0.156
Phillip
4 Avanti 1.01 300,000 12% 0.121
Feed
5 Karnataka 1.23 375,000 15% 0.190
Bank
Total 25,00,000 100% 0.814

The sum of the weighted beta is the overall Portfolio Beta. For the portfolio
above the beta is 0.814. This means, if Nifty goes up by 1%, the portfolio as a
whole is expected to go up by 0.81%. Likewise if Nifty goes down, the
portfolio is expected to go down by 0.81%.
Step 2 – Calculate the hedge value

Hedge value is simply the product of the Portfolio Beta and the total portfolio
investment
= 0.81 * 25,00,000
=2,025,000
Remember this is a long only portfolio, where we have purchased these stocks
in the spot market. We know in order to hedge we need to take a counter
position in the futures markets. The hedge value suggests, to hedge a portfolio
of Rs.25,00,000 we need to short futures worth Rs.2,025,000

Step 3- Calculate the number of lots required

On 26-02-2020 Nifty futures is trading at 11750, and with the current lot size of
75, the contract value per lot works out to –
= 11750 * 75
= Rs.881,250 /-
Hence the number of lots required to short Nifty Futures would be
= Hedge Value / Contract Value
= 2,025,000 / 881,250
= 2.29
The calculation above suggests that, in order to perfectly hedge a portfolio of
Rs.25,00,000/- with a beta of 0.81, one needs to short 2.29 lots of Nifty futures.
Clearly we cannot short 2.29 lots as we can short either 2 or 3 lots, fractional lot
sizes are not available.
If we choose to short 2 lots, we would be slightly under hedged. Likewise if we
short 3 units we would be over hedged. In fact for this reason, we cannot always
perfectly hedge a portfolio.
So on 24-03-2020.Nifty50 made low of 7511 down by 4,239 points (10.55%
down) from our level of shorting. With this we will calculate the effectiveness
of the portfolio hedge. Just for the purpose of illustration, I will assume we can
short 2.29 lots.
Nifty Position

Short initiated at – 11750

Decline in Value – 4239 points

Nifty value – 7511

Number of lots – 2.29

P & L = 2.29 * 75 * 4239 = Rs.728,048

The short position has gained Rs.728,048/-. We will look into what could have happened
on the portfolio.

Portfolio Position

Portfolio Value = Rs.25,00,000/-

Portfolio Beta = 0.81

Decline in Market = - 10.55%

Expected Decline in Portfolio = 10.55% * 0.81 = 8.54%

= 8.54% * 25,00,000

= Rs. 213,499

Portfolio Value = Rs.25,00,000 - 213,499 =22,86,501

So here we can see that Nifty Future Short has earned profit of Rs 728,048 and
our portfolio has declined to Rs 22,86,501
Here we can clearly see that our Short position not only Hedge our portfolio but
also made profit of 728,048 – 213,499 = 514,549
The point here is to note that-As we taken 2.29 lots of nifty futures. Clearly we
cannot short 2.29 lots as we can short either 2 or 3 lots, fractional lot sizes are
not available. So we cannot make conclusion or say that our portfolio has been
properly hedged.

Now we also need to check with the closing price of the stocks from date 20-02-
2020 to 24-03-2020.we have started hedging with Futures short from feb 20 and
closed our hedged position on march 24. By knowing actual closing price of
stocks we can check how well are portfolio has been hedged.

Decline in Portfolio stocks

Sr no Stock name Investment Closing Price Decline in

Price price
24-03-2020 Difference

1 Aarti Rs 840 Rs 694 - Rs 146

Industries
2 Crisil Rs 1540 Rs 1155 - Rs 385
3 Godfrey RS 960 Rs 750 - Rs 210
Phillip
4 Avanti Feed Rs 560 Rs 284 - Rs 276
5 Karnataka Rs 62 Rs 42 - Rs 20
Bank

Now let us find Decline in total investment

Sr no Stock Name Investment Quantit Total Decline in
price y of investment investment (-)
shares

1 Aarti Rs 840 890 Rs 750,000 Rs - 129,940

Industries
2 Crisil Rs 1540 405 Rs 625,000 Rs - 155,925
3 Godfrey RS 960 465 Rs 450,000 Rs - 97,650
Phillip
4 Avanti Feed Rs 560 535 Rs 300,000 Rs - 147,660
5 Karnataka Rs 62 6050 Rs 375,000 Rs – 121,000
Bank
Tota Rs 25,00,000 Rs – 652,175
l
So our portfolio has decline from Rs 25,00,000 – Rs 652,175 = Rs 18,47,825
Where else our Nifty Short position have earned Profit Rs 728,048
NET profit after hedging = Rs 728,048 – Rs 652,175 = Rs 75,873
So we not only have hedged our position but also made profit which can used
for Repurchasing of stocks at lower price and average down the buying price.
Advantage of beta hedging
Hedging with beta isn't tough to do, and it can balance the risk you take in a few
stocks or an entire portfolio.
Beta is a useful measurement for CAPM. It’s a straightforward, quantifiable
measure of risk. Knowing risk levels is helpful when investing and determining
costs of equity.
Limitation of beta hedging
The disadvantage of using beta is that it is based on historical data and may not
necessarily be an accurate predictor of future volatility. Beta doesn’t incorporate
or account for new information. For long term investments, beta isn’t as useful,
since it can change greatly over time
Beta will be reliable only if the stock trades frequently. The conclusions might
be biased if you find out the beta of an illiquid stock.
Beta just indicates volatility of a security in comparison to the market and not in
general. A security might be risky in nature but not correlated with market
returns (β=0).So, it should be used cautiously.
Conclusion
In the end, beta is a useful tool for determining short-term risk and for
calculating quantifiable measures of volatility to aid in finding equity costs. It
has its pros and cons – like any investing tool – but can be a great way to
establish the stability and the volatility in your portfolio. As for it being a
measure of risk that is useful to long term value investors, just avoid it
Beta will be reliable only if the stock trades frequently. The conclusions might
be biased if you find out the beta of an illiquid stock.
Beta just indicates volatility of a security in comparison to the market and not in
general. A security might be risky in nature but not correlated with market
returns (β=0).So, it should be used cautiously.
Beta does not provide the full picture of the company’s risk profile. It can be
useful for measuring short-term volatility but long-term investors will find it
less useful. Long-term investors will have to include multiple factors along with
market risk to get a full picture.

Hedging using Options

What Is an Option?
Options are financial instruments that are derivatives based on the value of
underlying securities such as stocks. An options contract offers the buyer the
opportunity to buy or sell—depending on the type of contract they hold—the
underlying asset. Unlike futures, the holder is not required to buy or sell the
asset if they choose not to.

 Call options allow the holder to buy the asset at a stated price within a
specific timeframe.
 Put options allow the holder to sell the asset at a stated price within a
specific timeframe.

Each option contract will have a specific expiration date by which the holder
must exercise their option. The stated price on an option is known as the strike
price. Options are typically bought and sold through online or retail brokers.

Option terminology
There are several terms used in the options market. Let us comprehend on each
of them
with the help of the following price:
Quote for Nifty Call option as on March 01, 2020
1. Instrument type : Option Index
2. Underlying asset : Nifty 50
3. Expiry date : March 01, 2020
4. Option type : Call European
5. Strike Price : 11800
Open price : 271.95
7. High price : 310.00
8. Low price : 233.25
9. Close price : 245.05
10. Traded Volume: 14,941 contracts
11. Open Interest: 9,83,775
12. Underlying value : 10154.20

Quote for Nifty Put option as on March 7, 2018

1. Instrument type : Option Index
2. Underlying asset : Nifty 50
3. Expiry date : March 01, 2020
4. Option type : Put European
5. Strike Price : 11800
6. Open price : 74.50
7. High price : 86.70
8. Low price : 66.55
9. Close price : 80.40
10. Traded Volume : 2,00,111 contracts
11. Open Interest : 40,83,000
12. Underlying value : 10154.20

Index option: These options have index as the underlying asset. For example
options on
Nifty, Sensex, etc.
Stock option: These options have individual stocks as the underlying asset. For
example,option on Reliance , BPCL , Infosys etc.
Buyer of an option: The buyer of an option is one who has a right but not the
obligation in the contract. For owning this right, he pays a price to the seller of
this right called ‘option premium’ to the option seller.
Writer of an option: The writer of an option is one who receives the option
premium and is thereby obliged to sell/buy the asset if the buyer of option
exercises his right.
American option: The owner of such option can exercise his right at any time
on or before the expiry date/day of the contract.
European option: The owner of such option can exercise his right only on the
expiry date/day of the contract. In India, Index options are European.

Option price/Premium: It is the price which the option buyer pays to the
option seller. In our examples, option price for call option is Rs. 245.05 and for
put option is Rs. 80.40. Premium traded is for single unit of nifty and to arrive
at the total premium in a contract, we need to multiply this premium with the lot
size.
Lot size: Lot size is the number of units of underlying asset in a contract. Lot
size of Nifty option contracts is 75. Accordingly, in our examples, total
premium for call option contract would be Rs 245 x 75= Rs 18378 and total
premium for put option contract would be Rs 80.40 x 75 = Rs 6030.
Expiration Day: The day on which a derivative contract ceases to exist. It is
the last trading date/day of the contract. Like in case of futures, option contracts
also expire on the last Thursday of the expiry month (or, on the previous trading
day, if the last Thursday is a trading holiday). In our example, since the last
Thursday (i.e., March 28, 2020) is a trading holiday, both the call and put
options expire one day before that i.e. on 27 March, 2020. (Please note that
Weekly Options expire on Thursday of each week. Weekly Options are the
Exchange Traded Options based on a Stock or an Index with shorter maturity of
one or more weeks. If the expiry day of the Weekly Options falls on a trading
Holiday, then the expiry will be on the previous trading day.)
Spot price (S): It is the price at which the underlying asset trades in the spot
market. In our examples, it is the value of underlying viz. 10154.20. Strike price
or Exercise price (X): Strike price is the price per share for which the
underlying security may be purchased or sold by the option holder. In our
examples, strike price for both call and put options is 10000.
In the money (ITM) option: This option would give holder a positive cash
flow, if it were exercised immediately. A call option is said to be ITM, when
spot price is higher than strike price. And, a put option is said to be ITM when
spot price is lower than strike price. In our examples, call option is in the
money.

At the money (ATM) option: At the money option would lead to zero cash
flow if it were exercised immediately. Therefore, for both call and put ATM
options, strike price is equal to spot price.

Out of the money (OTM) option: Out of the money option is one with strike
price worse than the spot price for the holder of option. In other words, this
option would give the holder a negative cash flow if it were exercised
immediately. A call option is said to be OTM, when spot price is lower than
strike price. And a put option is said to be OTM when spot price is higher than
strike price. In our examples, put option is out of the money.
Intrinsic value: Option premium, defined above, consists of two components ‐
intrinsic value and time value.
For an option, intrinsic value refers to the amount by which option is in the
money i.e. the amount an option buyer will realize, before adjusting for
premium paid, if he exercises the option instantly. Therefore, only in‐the‐money
options have intrinsic value whereas at‐the‐money and out‐of‐the‐money
options have zero intrinsic value. The intrinsic value of an option can never be
negative.
Thus, for call option which is in‐the‐money, intrinsic value is the excess of spot
price (S) over the exercise price (X). Thus, intrinsic value of call option can be
calculated as S‐X, with minimum value possible as zero because no one would
like to exercise his right under no advantage condition
Similarly, for put option which is in‐the‐money, intrinsic value is the excess of
exercise price (X) over the spot price (S). Thus, intrinsic value of put option can
be calculated as X‐S, with minimum value possible as zero.
Time value: It is the difference between premium and intrinsic value, if any, of
an option. ATM and OTM options will have only time value because the
intrinsic value of such options is zero.
Open Interest: As discussed in futures section, open interest is the total number
of option contracts outstanding for an underlying asset.
Exercise of Options In case of American option, buyers can exercise their
option any time before the maturity of contract. All these options are exercised
with respect to the settlement value/ closing price of the stock on the day of
exercise of option.
Assignment of Options Assignment of options means the allocation of
exercised options to one or more option sellers. The issue of assignment of
options arises only in case of American options because a buyer can exercise his
options at any point of time.

How to Hedge Using Options

Using options for hedging is, relatively speaking, fairly straightforward;

although it can also be part of some complex trading strategies. Many investors
that don’t usually trade options will use them to hedge against existing
investment portfolios of other financial instruments such as stock. There a
number of options trading strategies that can specifically be used for this
purpose, such as covered calls and protective puts.
The principle of using options to hedge against an existing portfolio is really
quite simple, because it basically just involves buying or writing options to
protect a position. For example, if you own stock in Company X, then buying
puts based on Company X stock would be an effective hedge.
Most options trading strategies involve the use of spreads, either to reduce the
initial cost of taking a position, or to reduce the risk of taking a position. In
practice most of these options spreads are a form of hedging in one way or
another, even this wasn't its specific purpose.
For active options traders, hedging isn't so much a strategy in itself, but rather a
technique that can be used as part of an overall strategy or in specific strategies.
You will find that most successful options traders use it to some degree, but
your use of it should ultimately depend on your attitude towards risk.
 Hedging using stock Options
Let us recall about unsystematic risk. So what is unsystematic risk ? How does
it affect our portfolio.

Understanding Unsystematic Risk

Unsystematic risk is unique to a specific company or industry. Also known as
“nonsystematic risk,” "specific risk," "diversifiable risk" or "residual risk," in
the context of an investment portfolio, unsystematic risk can be reduced
through diversification.
Unsystematic risk can be described as the uncertainty inherent in a company or
industry investment. Types of unsystematic risk include a new competitor in the
marketplace with the potential to take significant market share from the
company invested in, a regulatory change (which could drive down company
sales), a shift in management, and/or a product recall.

While investors may be able to anticipate some sources of unsystematic risk, it

is impossible to be aware all or when/how these might occur.

For example, an investor, who owned airline stocks Inter globe Aviation
(Indigo) would face a high level of unsystematic risk. An investor is vulnerable
if airline industry is put on a halt or has been kept for temporary ban on
travelling. This event could sink airline stock prices, even temporarily. Simply
the anticipation of this news could be disastrous for his portfolio.

Another example is an investor is long in cash market on PVR Cinemas. Due

to covid-19 pandemic the government has put ban on all theatre’s and cinema
hall. This will probably put pressure on PVR cinema which is likely to decline.

Any investor, long in the cash market, always runs the risk of a fall in prices and
thereby reduction of portfolio value and MTM losses. A investor , who is
anticipating a fall, can either sell his entire portfolio or use options to hedge his
portfolio. In both cases, he is out of the market, as far as profits from upside are
concerned. What can be done to remain in the market, reduce losses but gain
from the upside? Buy insurance!

In this section, we will see safe and most commonly used strategy.
 Protective Put – A Hedging Strategy for Stock Investments

What Is a Protective Put?

A protective put is a risk-management strategy using options contracts that

investors employ to guard against the loss of owning a stock or asset. The
hedging strategy involves an investor buying a put option for a fee, called a
premium.

By buying put options, an investor is effectively taking a bearish view on the

market and if his view turns right, he will make profits on long put, which will
be useful to negate the MTM losses in the cash market portfolio.

For the cost of the premium, protective puts act as an insurance policy by
providing downside protection from an asset's price declines.

Strike Prices and Premiums

A protective put option contract can be bought at any time. Some investors will
buy these at the same time and when they purchase the stock. Others may wait
and buy the contract at a later date. Whenever they buy the option, the
relationship between the price of the underlying asset and the strike price can
place the contract into one of three categories—known as the moneyness. These
categories include:

1. At-the-money (ATM) where strike and market are equal

2. Out-of-the-money (OTM) where the strike is below the market
3. In-the-money (ITM) where the strike is above the market

Investors looking to hedge losses on a holding primarily focus on the ATM and
OTM option offerings.

Should the price of the asset and the strike price be the same, the contract is
considered at-the-money (ATM). An at-the-money put option provides an
investor with 100% protection until the option expires. Many times, a protective
put will be at-the-money if it was bought at the same time the underlying asset
is purchased.
An investor can also buy an out-of-the-money (OTM) put option. Out-of-the-
money happens when the strike price is below the price of the stock or asset. An
OTM put option does not provide 100% protection on the downside but instead
caps the losses to the difference between the purchased stock price and the
strike price. Investors use out-of-the-money options to lower the cost of the
premium since they are willing to take a certain amount of a loss. Also, the
further below the market value the strike is, the less the premium will become.

Example of a Protective Put

Let's say an investor purchased 1000 shares of Interglobe Aviation (Indigo)

stock bought at Rs 950 per share. The price of the stock increased to Rs 1200
giving the investor Rs 250 per share in unrealized gains—unrealized because
it has not been sold yet.

But now due to covid-19 situation the government has put temporary ban on
all air travels .Which is likely to impact airline stocks to decline in price. The
investor does not want to sell his holdings, because the stock might
appreciate in after situation get back to normal . He also do not want to lose
the Rs 250 in unrealized gains. Here the investor can purchase a put option
for the stock to protect a portion of the gains for as long as the option contract
expiry.

The investor buys a put option with a strike price of Rs 1200 of March expiry
by paying Rs 30 anywhere below Rs 1200, the investor is hedged until the
option expires that is till march

Here the investor needs to buy 2 Lots of put options of Rs 1200 strike Price

The option premium cost is RS 30 (RS 30 x 1000 shares).=RS 30,000

Now, if prices fall to RS 1000 from RS 1200

Long Cash Position : Loss of 1200 – 1000 = - 200

Long Put: Profit of – 30 – 1000 + 1200 = 170

Net Position: ‐30

For all falls in the market, the long put will turn profitable and the long cash
will turn loss making, thereby reducing the overall losses only to the extent of
premium paid (if strikes are different, losses will be different from premium
paid)
In case prices rise to 1300 on expiry
Long Cash: Profit of 1300 – 1200 = 100
Long Put: Loss of 30
Net Position: 100– 30 = 70
As price keeps rising, the profits will keep rising as losses in long put will be
maximum to the extent of premium paid, but profits in long cash will keep
increasing. Combined position would look like as follows:

Here the investor has bearish view on stock so he has purchased At the money
(ATM) Put option by paying RS 30 as premium.

Buying Price in Cash Market RS 950

Current Market Price RS 1200
Strike price of Put Bought RS 1200
Premium Paid RS 30

CMP Long in Cash Long Put Net P&L

1325 125 -30 95
1300 100 -30 70
1275 75 -30 45
1250 50 -30 20
1225 25 -30 -5
1200 0 -30 -30
1175 -25 -5 -30
1150 -50 20 -30
1125 -75 50 -30
1100 -100 70 -30
1075 -125 95 -30
1050 -150 120 -30
1025 -175 145 -30
1000 -200 170 -30

A protective put keeps downside losses limited while preserving unlimited

potential gains to the upside. However, the strategy involves being long the
underlying stock. If the stock keeps rising, the long stock position benefits and
the bought put option is not needed and will expire worthlessly. All that will be
lost is the premium paid to buy the put option. In this scenario where the
original put expired, the investor will buy another protective put, again
protecting his holdings.
 The maximum loss of a protective put strategy is limited to the cost of buying
the underlying stock—along with any commissions—less the strike price of the
put option plus the premium and any commissions paid to buy the option.

Risks of a Protective Put

The protective put is a risk management or hedging strategy, so the risks are
limited as we described above. You can still lose money using a protective put,
but large losses are mitigated in this strategy. For the protection offered by this
strategy, you do sacrifice a small portion of the profits if the value of the stock
increases, because of the premium paid to acquire the put option. The other
main risk is time, as the protection offered by the strategy will end once the
option expires.

Pros of Protective Put Strategy

 For the cost of the premium, protective puts provide downside protection
from an asset's price declines.
 Protective puts allow investors to remain long a stock offering the
potential for gains.
 No gapping risk while the hedge is on

Cons of Protective Put Strategy

 If an investor buys a put and the stock

price rises, the cost of the premium reduces the profits on the trade.
 If the stock declines in price and a put
has been purchased, the premium adds to the losses on the trade.
 Often costs more when the true “need”
arises
 Scope and Limitation of studies
Scope
 The research highlights the importance of hedging portfolio from steep
market fall.

 The research explains the stock beta and is calculated and used to hedge
the portfolio stocks which are not part derivatives.

 The research explains how derivatives like future and options can be
used hedge the portfolio.

Limitation
 The process of portfolio hedging or hedging stocks is a trade-off.
There is usually a cost, and there is no guarantee that a hedge will
perform as planned. A significant hedging risk can come from a
mismatch between the portfolio being hedged and the instrument
being used to hedge. Constructing a hedge that accurately matches a
portfolio is very costly, so the mismatch has to be accepted.

 Hedging stocks can only be feasibly done once or twice a year. If the
market rises after a hedge is implemented, the new gains won’t be
protected. In addition, time decay devalues options rapidly as expiry
approaches. The price at which options are valued in a portfolio is
based on daily mark to market prices. These prices are subject to
market forces and increase portfolio volatility even when they protect
its ultimate value. Buying options requires margin to be paid out. To
do this, cash has to be borrowed using the portfolio as collateral. This
will usually come with a cost.

Conclusion

Risk and uncertainty are a given when it comes to financial markets. While risks
can seldom be avoided completely, portfolio hedging is one way to protect a
portfolio against a potential loss. Hedging stocks does come at a cost but can
give investors peace of mind. This can help investors take on enough risk
to achieve long-term investment goals. Hedging can also prevent catastrophic
losses.
 References
https://catanacapital.com/blog/portfolio-hedging-ways-to-hedge-stock-portfolio-
reduce-market-risk/
https://www.vskills.in/certification/tutorial/commodity-dealer/advantages-and-
disadvantages-of-hedging/
https://www.investopedia.com/
https://www1.nseindia.com/
https://traderslounge.in/portfolio-hedging-indian-stocks/
https://www.researchgate.net/publication/334123608_Hedging_Strategy_Influe
ncing_Derivative_Investment_on_Investors
https://www.motilaloswal.com/blog-details/How-to-hedge-your-risk-using-
options-positions/1641
NISM-Series-VIII: Equity Derivatives