Hedging with Equity Index Futures - Beta Adjusted
- 02:40
Use betas to hedge portfolios that are more/less sensitive than the market.
Downloads
No associated resources to download.
Glossary
beta adjusted equity index futures hedgeTranscript
While a basic futures hedge calculated as the portfolio value divided by the futures contract value. While this is straightforward and intuitive, it works well only when there's a strong negative correlation between the cash equity position and the equity futures position, ideally minus one. However, it does have limitations. If a portfolio consists of stocks that tend to generally move in line with the market, But with a greater magnitude such as a portfolio tilted towards growth stocks, the basic hedge may fall short. For example, if index futures fall by 10%, the portfolio might decline by more than 10%. In this case, the hedge would still generate a profits, but it wouldn't be enough to fully offset the larger losses in the portfolio. To account for this increased sensitivity, we can use what's called a beta adjusted hedge, which considers the individual risk of the portfolio relative to the index futures.
But what does beta mean in this context? Beta is a measure of an equity portfolio's sensitivity to market movements. It's calculated by comparing the returns of the cash portfolio with the returns of the underlying index, and indicates the relative volatility of the portfolio versus the index.
A beta of one means that the portfolio will move in line with the broad market of the index. A beta of greater than one indicates higher sensitivity to market movements, while a beta less than one indicates lower sensitivity. For instance, a portfolio with a beta of two moves in the same direction as the market, but at twice the speed. This means it's expected to gain twice as much as the index does when it rises, but also to lose twice as much when the index falls. Conversely, a portfolio with a beta of 0.5 would move in the same direction as the market, but only half as much gaining or losing at half the rate of the broader market.