To Hedge, itself means protection and safety. It is one type of risk management system that involves purchasing or selling your investment to reduce the level of risk in the future. Whenever you make a trade in the stock market, one factor is always associated with it, and that is a risk. It can be either actual or notional, but it is there, and the procedure to avoid that is called hedging.
The easiest and most secure way of hedging is to sell an equal amount of market position futures. In simpler terms, you have 15 lakhs in the equities in a long position, and you are selling 15 lakhs of futures. This is the perfect example of hedging your position.
But this can only happen when you have only one stock or property. What if you have a portfolio of stock? In such cases, it becomes pretty complex to sell futures for every stock, which also does not make any sense. The main purpose of creating the portfolio is to diversify the risk associated and reduce the risk by some level.
There are always 2 types of risk associated: Systematic Risk and Unsystematic Risk.
Unsystematic risk is unique to particular stocks and industries, and to reduce these unsystematic risks, portfolios are created. Any intelligent portfolio manager can diversify your Unsystematic Risk by creating a profitable portfolio.
Still, he cannot reduce the Systematic Risk involved because this is affected by factors such as GDP, inflation, Political risk, SEBI rules, Geography risk, and many more; these are beyond hedging, and that's why Beta Hedging takes place.
Beta helps in measuring the systematic risk that is unavoidable otherwise. When you see a beta value of more than 1 is known as aggressive stock, and when it is less than 1, it's defensive stock. Please also note that the beta value of indexes like Nifty is always 1. So, when you want to hedge the portfolio, you must go with beta hedging.
Beta hedging can be understood simply by the following: If a stock has a beta of 1.2, then it says that a 10 % movement in the index will result in a 12 % movement in the stocks. It is applicable on both sides, whether a positive change or a negative one. If you know the stock's beta value, you can apply the same to your portfolio and hedge your money.
Let us understand what is Beta hedging usage with an example:
A Long term investor has a portfolio of 6 different stocks, as mentioned below:
As the portfolio value changes, the value of beta will also change. As the value of beta reaches above 1, it will be classified as an aggressive portfolio.
The investor has to sell the equity of beta times portfolio value;
Here in our case ( 61,50,000* 1.1532) = Rs. 70,92,180
Since the Nifty futures are traded in the minimum lots set by SEBI, you need to sell your stocks in lots. The current size of the Lot is set to 75 Units.
Please remember that you cannot sell nifty in any fraction amount, such as 3.5 or 4.7. You either have to choose 3,4, 5 or 6 if you get the figure above.
We hope you understand how you can use Beta Hedging and try to avoid Systematic Risk and Unsystematic Risk in Portfolio Beta.