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Using Index Futures to Hedge Market Risk
How might a portfolio manager use futures to hedge market exposure? Suppose, for
example, that you manage a $30 million portfolio with a beta of .8. You are bullish on the
Got a Bundle to Invest Fast? Think Stock-Index Futures
As investors go increasingly global and market turbulence
grows, stock-index futures are emerging as the favorite
way for nimble money managers to deploy their funds.
Indeed, in most major markets, trading in stock futures
now exceeds the buying and selling of actual shares.
What’s the big appeal? Speed, ease and cheapness. For
most major markets, stock futures not only boast greater
liquidity but also lower transaction costs than traditional
trading methods.
“When I decide it’s time to move into France, Germany
or Britain, I don’t necessarily want to wait around until
I find exactly the right stocks,” says Fabrizio Pierallini,
manager of New York–based Vontobel Ltd.’s Euro Pacific
Fund.
Mr. Pierallini says he later fine-tunes his market picks
by gradually shifting out of futures into favorite stocks.
To the extent Mr. Pierallini’s stocks outperform the mar-
ket, futures provide a means to preserve those gains, even
while hedging against market declines.
For instance, by selling futures equal to the value of
the underlying portfolio, a manager can almost completely
insulate a portfolio from market moves. Say a manager suc-
ceeds in outperforming the market, but still loses 3% while
the market as a whole falls 10%. Hedging with futures
would capture that margin of out-performance, transform-
ing the loss into a profit of roughly 7%.
Among futures-intensive strategies is “global tactical
asset allocation,” which involves trading whole markets
worldwide as traditional managers might trade stocks. The
growing popularity of such asset-allocation strategies has
given futures a big boost in recent years.
To capitalize on global market swings, “futures do the
job for us better than stocks, and they’re cheaper,” said
Jarrod Wilcox, director of global investments at PanAgora
Asset Management, a Boston-based asset allocator. Even
when PanAgora does take positions in individual stocks,
it often employs futures to modify its position, such as by
hedging part of its exposure to that particular stock market.
When it comes to investing overseas, Mr. Wilcox noted,
futures are often the only vehicle that makes sense from
a cost standpoint. Abroad, transaction taxes and sky-high
commissions can wipe out more than 1% of the money
deployed on each trade. By contrast, a comparable trade in
futures costs as little as 0.05%.
Source: Abridged from Suzanne McGee, “Got a Bundle to Invest Fast?
Think Stock-Index Futures,” The Wall Street Journal, February 21,
1995. Reprinted by permission of The Wall Street Journal, © 1995
Dow Jones & Company, Inc. All rights reserved worldwide.
WORDS FROM THE STREET
3
One might also attempt to exploit violations of parity using ETFs linked to the market index, but ETFs may trade
in less liquid markets where it can be difficult to trade large quantities without moving prices.
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C H A P T E R
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Futures, Swaps, and Risk Management
811
market over the long term, but you are afraid that over the next 2 months, the market is
vulnerable to a sharp downturn. If trading were costless, you could sell your portfolio,
place the proceeds in T-bills for 2 months, and then reestablish your position after you
perceive that the risk of the downturn has passed. In practice, however, this strategy would
result in unacceptable trading costs, not to mention tax problems resulting from the real-
ization of capital gains or losses on the portfolio. An alternative approach would be to use
stock index futures to hedge your market exposure.
Suppose that the S&P 500 index currently is at 1,000. A decrease in the index to 975
would represent a drop of 2.5%. With a portfolio beta of .8, you would expect a loss
of .8 3 2.5% 5 2%, or in dollar terms, .02 3 $30 million 5 $600,000. Therefore, the
sensitivity of your portfolio value to market movements is $600,000 per 25-point move-
ment in the S&P 500 index.
To hedge this risk, you could sell stock index futures. When your portfolio falls in value
along with declines in the broad market, the futures contract will provide an offsetting profit.
The sensitivity of a futures contract to market movements is easy to determine. With
its contract multiplier of $250, the profit on the S&P 500 futures contract varies by
$6,250 for every 25-point swing in the index. Therefore, to hedge your market exposure
for 2 months, you could calculate the hedge ratio as follows:
H
5
Change in portfolio value
Profit on one futures contract
5
$600,000
$6,250
5 96 contracts (short)
You would enter the short side of the contracts, because you want profits from the con-
tract to offset the exposure of your portfolio to the market. Because your portfolio does
poorly when the market falls, you need a position that will do well when the market falls.
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