Take for example an issue like labour unrest. If Maruti Suzuki is facing an industrial dispute at a point in time, it will usually not be the case that Bajaj Auto or Tata Motors is facing a similar problem at the same point in time. Thus, idiosyncratic risk is known as diversifiable risk. However, no amount of diversification can totally eliminate the risk faced by an investor. There is risk on account of economy-wide or macro factors. For instance, if the inflation rate in India were to be higher than anticipated, the impact would be felt by all companies, albeit to different degrees. Similarly, if the rating agencies were to downgrade India, there would be implications for multiple companies across various industries. Thus, this kind of risk is non-diversifiable, and is known as market risk.
The issue, therefore, is how does one deal with this kind of risk For, we may have a well-diversified portfolio with components from the entire economic spectrum but what if the Sensex tanks by a 1,000 points It will obviously drag down every asset with it. So, we need tools that can help us to confront this kind of market risk without trepidation. Futures contracts are one such potential tool. As anybody who has studied derivatives would know, a spot position is risky; a futures position in isolation is risky; but a long-spot position, coupled with a short futures position, can be perfectly risk-less.
So, one possibility is to use Sensex or Nifty futures to mitigate the risk of our stock portfolio. The number of contracts required would depend on the Beta of our portfolio, where Beta is a measure of the market risk of the asset or asset portfolio. If we structure our hedging strategy properly we can make our overall position perfectly risk-less. And, such a portfolio would obviously give us the risk-less rate of return, for any other outcome would connote the potential for arbitrage.
However, most of the time we would seek to de-risk a fraction of our portfolio and let the remaining component remain as a risky asset. The risk-less component would earn the risk-less rate, while the risky component will have a lower bound of zero due to the limited liability feature. Thus, this strategy will give rise to a floor value for the portfolio. That is, the basket of securities may earn a higher return, but cannot give a lower yield. Such risk mitigation strategies are known as Portfolio Insurance strategies. Such a strategy is usually implemented in a dynamic fashion. If the fund manager were to be very bearish about the market, then he would seek to insure a larger component of the portfolio. To do so, he would need to go short in more futures contracts. However, if his outlook were to turn bullish, then he would offset his short futures position partially, by going long in index futures.
Futures contracts can also be used to modify the beta of an asset or a portfolio. To increase the beta, we would need to go long in futures, while to reduce the beta, we would need to take a short position.
Options contracts can also be used from the standpoint of portfolio insurance. One approach is to use index-based put options. The puts can either be acquired from the market, or else they can be replicated using a combination of positions in stock as well as risk-less debt. These are known as static and dynamic portfolio insurance strategies, respectively. Those of us who are aware of option theory will know that the values of calls and puts on the same underlying asset are related to the value of the underlying by what is termed as the Put-Call Parity relationship. Hence, the put options required to provide insurance can be synthetically generated by taking a suitable position in call options.
Portfolio insurance strategies have attracted their share of controversy. One allegation is that they make markets more volatile. The rationale that is expounded is that in a falling market, bearish portfolio managers will take larger short positions in futures contracts. The sale of futures on a large scale will cause the price of such contracts to get depressed, which will lead to southward moves in the prices of the underlying assets, since spot and futures prices are linked by the Cost of Carry relationship. But the jury is still out on this hypothesis. Empirical research has been unable to demonstrate conclusively that portfolio insurance strategies have unwanted ramifications for market volatility. Besides, the question is, is volatility always undesirable Volatility is often a manifestation of an informationally efficient market. The absorption of fresh information by the market will cause asset prices to correct, and give rise to what is termed as volatility. However, volatility can also be induced by factors without an economic origin, and this is not deemed to be desirable.
The writer is the author of Fundamentals of Financial Instruments, published by Wiley, India