Can you explain to me what is beta hedging and how can I really apply it to my portfolio of stocks?
Answer
Answer
Did you know that you can do a beta hedge of a large portfolio, but it is essential that these are part of the Nifty or at least, large enough. This would also apply more for a portfolio than for individual stocks. As you must be aware, Beta is a measure of systematic risk, which is the risk that cannot be diversified away. A beta of more than 1 means that it is an aggressive stock and a beta of less than 1 means that it is a defensive stock. The beta of an index like Nifty or the Sensex is always 1. How would Beta hedge work really work?
Here is a portfolio of 5 non-F&O stocks
Serial Number
Stock Name
Stock Beta
Investment Amount
1
Stock A
1.22
Rs.4,50,000
2
Stock B
1.15
Rs.5,50,000
3
Stock C
1.18
Rs.3,50,000
4
Stock D
1.45
Rs.6,00,000
5
Stock E
1.25
Rs.2,80,000
Total Value
Rs.22,30,000
The above portfolio of non-F&O stocks is worth Rs.22.30 lakhs. Each stock has a beta based on past price data. In the above portfolio, all stocks are aggressive stocks with Beta more than 1. That means even the portfolio beta will be more than 1. Let us see how this works out to calculate the portfolio beta.
Calculating the portfolio beta
Stock Name
Stock Value
Stock Weight
Stock Beta
Weighted Beta
Stock A
Rs.4,50,000
20.18%
1.22
0.2462
Stock B
Rs.5,50,000
24.66%
1.15
0.2836
Stock C
Rs.3,50,000
15.70%
1.18
0.1853
Stock D
Rs.6,00,000
26.91%
1.45
0.3902
Stock E
Rs.2,80,000
12.55%
1.25
0.1569
Rs.22,30,000
100.00%
Weighted Beta
1.2622
Portfolio beta is nothing but the weighted average of individual stock betas. How do we calculate the weights of various stocks? It represents the relative weight of the stock in the index. In the above example if all the 5 stocks are weighted to the overall portfolio and then the weighted beta is calculated for each stock, then the total portfolio beta comes to 1.2622. This is called the hedge ratio.
How to do Beta hedging with hedge ratio
In the above case the portfolio value is Rs.22.30 lakhs and that the weighted beta of the portfolio is 1.2622. Here is how to do beta hedging!
Calculation for beta hedging
Value of the Portfolio – Rs.22,30,000/-
Weighted beta of portfolio – 1.2622
Value of Futures to be shorted – Rs.28,14,706 (22,30,000 x 1.2622)
Since the value of 1 lot of Nifty futures (lot size 75) is Rs.820,950 you need to sell 3.43 lots (28,14,706 / 8,20,950). Since you cannot sell fractional lots, you can sell either 3 or 4 lots of Nifty to hedge your non-F&O portfolio. Again, fractional hedging makes this method also imperfect to an extent.