Hedging Techniqu

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HEDGING TECHNIQUES

IN

MUTUAL FUNDS

(Franklin Templeton)

Submitted to Lovely Professional University

In partial fulfillment of the

Requirements for the award of Degree of

Master of Business Administration

Submitted by Guided by

Arun Sharma Mrs. Shelly

Registration No. 2020070160 Lecturer (Mgt)

LSB

DEPARTMENT OF MANAGEMENTLOVELY PROFESSIONAL UNIVERSITY

PHAGWARA

(2007-09)


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HEDGING TECHNIQUES IN MUTUAL FUNDS

OBJECTIVES OF THE STUDY

The purpose of this study is to examine the effectiveness of hedging mutual fund returns

using Index Futures Contracts. Additionally, the study allows understanding the various

issues, such as

1. To study, how hedging techniques reduces the risk in investment.

2. To study the application of derivatives in Mutual funds.

3. To comparison of before and after returns of hedging funds.

Lovely Professional University2

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RESEARCH METHODOLOGY

Since the objective is to analyze the effectives of hedging in mutual funds, the data

required is the fact sheet of the mutual fund for the relevant period. Further, from the use

website, the relevant details of derivatives contract were captured.

DATA COLLECTION

There was one method for the data collection:

Secondary Data

The mechanism involved in secondary data collection, mainly browsing through adequate

journal (related to mutual funds and derivatives), collection of fact sheet of the mutual

fund from the AMC, web portals, & books etc.

Quantitative analysis required ascertaining the returns of the mutual funds for the certain

period and then for same period calculated the hedged returns. Thus, compared both the

returns to arrive at better results.

METHODOLOGY

Mutual Funds: This study uses the daily returns of mutual funds such as Franklin

Bluechip Fund, Franklin Infotech Fund and Franklin Prima fund. The entire funds taken

are growth funds. Daily NAV data was obtained from Association of Mutual Funds in

India and computed daily returns from this data.

After this, I used Chi-Square test to check that Is the Mutual Funds returns are equal to

hedging returns or not ? By this I come to know how hedging returns are reduced the risk

and also comparison of before and after hedging returns.


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Index Futures Contracts: Financial futures provide institutional investors with the

opportunity to hedge their financial risk. These futures are low cost flexible instruments

that can be used as a risk management tool. Similarly, index futures can be used as a

hedge for wide range of

stock, which forms its underlying stock base. The idea of an index future is to provide a

mechanism for fixing returns on the market portfolio. The key to hedging with stock

index futures is that the futures position combined with the exiting cash market position

yields a desired exposure to risk on the overall investment in the underlying asset. This in

effect helps the portfolio manager to alter the market risk on his portfolio without

changing the portfolio composition.

I have used S&P CNX Nifty and CNX IT as hedging instruments for this study. These

contracts were selected based on the concept that the most suitable hedgers for Franklin

Templeton would be the index futures that were written on same or similar underlying

assets. All futures contract selected for this study are liquid in nature. Futures contract

prices are obtained from NSE website. Future contracts mature last Thursday of every

month and there will be three types available based on the maturity, but I have taken the

near month expiry, as the study is based on short term horizon.


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1. INTRODUCTION TO MUTUAL FUNDS

1.1 History

The concept of mutual funds was introduced in India with the formation of Unit Trust of

India in 1963. The first scheme launched by UTI was the now infamous Unit Scheme 64

in 1964. UTI continued to be the sole mutual fund until 1987, when some public sector

banks and Life Insurance Corporation of India and General Insurance Corporation of

India set up mutual funds. It was only in 1993 that private players were allowed to open

shops in the country. Today, 32 mutual funds collectively manage Rs 6713575.19 cr.

under hundreds of schemes.

The industry faced its toughest challenge when the US 64 fiasco shattered the confidence

of investors. However, in 2003, the government bifurcated the erstwhile UTI. One entity

manages the assets of US 64 and some assured return schemes. The other is a regular

mutual fund working under the Sebi regulations. Thanks to the boom in the stock market,

UTI managed to clean up its act and continue to enjoy the confidence of several

investors. The whole industry also came out of the controversy without any major

setbacks.

In the past decade, Indian mutual fund industry had seen a dramatic improvements, both

quality wise as well as quantity wise. Before, the monopoly of the market had seen an

ending phase, the Assets Under Management (AUM) was Rs. 67bn. The private sector

entry to the fund family rose the AUM to Rs. 470 bn in March 1993 and till April 2004, it

reached the height of 1,540 bn.

Putting the AUM of the Indian Mutual Funds Industry into comparison, the total of it isless than the deposits of SBI alone, constitute less than 11% of the total deposits held by

the Indian banking industry.

The main reason of its poor growth is that the mutual fund industry in India is new in the

country. Large sections of Indian investors are yet to be intellectuated with the concept.


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Hence, it is the prime responsibility of all mutual fund companies, to market the product

correctly abreast of selling.

1.2 Meaning of Mutual Fund

Definition: A mutual fund is simply a financial intermediary that allows a group of

investors to pool their money together with a predetermined investment objective. The

mutual fund will have a fund manager who is responsible for investing the pooled money

into specific securities (usually stocks or bonds). When you invest in a mutual fund, you

are buying shares (or portions) of the mutual fund and become a shareholder of the fund.

Mutual funds are one of the best investments ever created because they are very cost

efficient and very easy to invest in (you don't have to figure out which stocks or bonds to

buy).

The flow chart below describes broadly the working of a mutual fund.

Figure 1

Further, Mutual Funds business acts according to the wishes of the investors who created

the pool. In many markets these wishes are translated in to investment

mandates. Generally, the investors appoint professional investment managers,

to mange their funds. The same objective is achieved when professional

investment managers create a product , and offer it for investment to the


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investor. This product represents a share in the pool, and pre-states investment

objectives. For example, a mutual fund, which sells a money market mutual

fund is actually obtained investors willingness to invest in a pool that would

invest predominantly in money market instruments.

1.3 Organisation Structure of a Mutual Fund

There are many entities involved and the diagram below illustrates the organizational set

up of a mutual fund

Figure 2

The sponsor is the promoter of a mutual fund. The sponsor establishes the mutual fund

and registers the same with SEBI. Further, Sponsor appoints the trustees,

custodians and the AMC with prior approval of SEBI, and accordance with

SEBI regulations. All the entities are entitled to comply with certain regulatory

requirements. Let us discuss the regulatory requirements of trustees and AMC.

Regulatory requirements for trustees: The mutual fund, which is a trust, is managed either

by a trust company or a board of trustees. Board of trustees and trust

companies are governed by the provisions of the Indian Trust Act. If the


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trustee is a company, it is also subject to the provisions of the Indian

Companies Act. It is the responsibilities of the trustees to protect the interest of

investors, whose fund is managed by the AMC.

Regulatory requirements for the AMC: It is applicable only to the SEBI registered AMCs

can be appointed as investment managers of mutual funds. AMCs are required

to have the minimum net worth of Rs. 10 crores at all times. AMCs are not

allowed to be the trustee of another mutual fund. The investment management

agreement entered into between the trustees and the AMC, spells out the rights

and obligations of both the parties.

1.4 Types of MF

Figure 3

MF schemes can be classified under two broad heads, namely schemes according tomaturity period and schemes according to investment objective.


8

MU

SCHEMES A CCORDING

TO MA TURITY


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Schemes according to maturity period:

A mutual fund scheme can be classified into open-ended scheme or close-ended scheme

depending on its maturity period.

Open-ended fund or scheme:

An open-ended fund or scheme is one that is available for subscription and repurchase on

a continuous basis. These schemes do not have a fixed maturity period. Investors can

conveniently buy and sell units at Net Asset Value (NAV) related prices which are

declared on a daily basis. The key feature of open-end schemes is liquidity.

CRISIL's composite performance ranking (CPR) measures the performance for each of

the open-ended scheme of Mutual Fund. There are four parameters considered to measure

the performance of a mutual fund such as Risk-adjusted returns of the scheme's NAV,

Diversification of Portfolio, Liquidity and Asset Size.

Closed-end fund/scheme:

A close-ended fund or scheme has a stipulated maturity period e.g. 5-7 years. The fund is

open for subscription only during a specified period at the time of launch of the scheme.

Investors can invest in the scheme at the time of the initial public issue and thereafter

they can buy or sell the units of the scheme on the stock exchanges where the units are

listed. In order to provide an exit route to the investors, some close-ended funds give an

option of selling back the units to the mutual fund through periodic repurchase at NAV

related prices. SEBI Regulations stipulate that at least one of the two exit routes is

provided to the investor i.e. either repurchase facility or through listing on stock

exchanges. These mutual funds schemes disclose NAV generally on weekly basis.

Schemes according to investment objective:

A scheme can also be classified as growth scheme, income scheme, or balanced scheme

considering its investment objective. Such schemes may be open-ended or close-ended

schemes as described earlier. Such schemes may be classified mainly as follows


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Growth / Equity Oriented Scheme:

The aim of growth funds is to provide capital appreciation over the medium to long-

term. Such schemes normally invest a major part of their corpus in equities. Such funds

have comparatively high risks. These schemes provide different options to the investors

like dividend option, capital appreciation, etc. and the investors may choose an option

depending on their preferences. The investors must indicate the option in the application

form. The mutual funds also allow the investors to change the options at a later date.

Growth schemes are good for investors having a long-term outlook seeking appreciation

over a period of time.

Income / Debt Oriented Scheme:

The aim of income funds is to provide regular and steady income to investors. Such

schemes generally invest in fixed income securities such as bonds, corporate debentures,

Government securities and money market instruments. Such funds are less risky

compared to equity schemes. These funds are not affected because of fluctuations in

equity markets. However, opportunities of capital appreciation are also limited in such

funds. The NAVs of such funds are affected because of change in interest rates in the

country. If the interest rates fall, NAVs of such funds are likely to increase in the short

run and vice versa. However, long term investors may not bother about these fluctuations.

Balanced Fund:

The aim of balanced funds is to provide both growth and regular income as such schemes

invest both in equities and fixed income securities in the proportion indicated in their

offer documents. These are appropriate for investors looking for moderate growth. They

generally invest 40-60% in equity and debt instruments. These funds are also affected

because of fluctuations in share prices in the stock markets. However, NAVs of such

funds are likely to be less volatile compared to pure equity funds.


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Money Market or Liquid Fund:

These funds are also income funds and their aim is to provide easy liquidity, preservation

of capital and moderate income. These schemes invest exclusively in safer short-term

instruments such as treasury bills, certificates of deposit, commercial paper and inter-

bank call money, government securities, etc. Returns on these schemes fluctuate much

less compared to other funds. These funds are appropriate for corporate and individual

investors as a means to park their surplus funds for short periods.

Gilt Fund:

These funds invest exclusively in government securities. Government securities have no

default risk. NAVs of these schemes also fluctuate due to change in interest rates and

other economic factors as is the case with income or debt oriented schemes.

Index Funds:

Index Funds replicate the portfolio of a particular index such as the BSE Sensitive index,

S&P NSE 50 index (Nifty), etc. These schemes invest in the securities in the same weight

age comprising of an index. NAVs of such schemes would rise or fall in accordance with

the rise or fall in the index, though not exactly by the same percentage due to some

factors known as "tracking error" in technical terms. Necessary disclosures in this regard

are made in the offer document of the mutual fund scheme.

Some helpful rules to invest in mutual funds :-

Mutual Funds are increasingly being touted as the retail investors' investment vehicle.

But the key challenge is to choose the right fund. But it's simple. It only requires a bit of

discipline and little time - hardly a cost for a secure financial future. Following are some

rules to help invest better and attain your financial goals.

Know Yourself: The first step towards achieving your goals is that you must know

yourself. Try to get an idea of how much risk you can handle. Do a tolerance test for


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yourself. If your Rs 10,000 investment turning into Rs 6,000 up sets you--even though it

could subsequently bounce back--an aggressive equity fund is not for you.

Reality Check: What are your goals? If you need to turn Rs 10,000 into Rs 50,000 in

two years, a medium term bond fund may not be the right answer. Work on setting

realistic expectations for both your goals and your funds.

Know What You Are Buying: Once you discovered yourself, spend some time for a

close understanding of the funds. The stated objective of a fund as given in a prospectus

is often incomplete and does not reveal much. Based on the readily available portfolio

and fund manager's commentary, you can broadly understand the style and strategy

followed by a fund. This will help you meaningfully diversify your portfolio. This will

also help you assess potential risks. In general, large-cap value funds are less risky than

small-cap growth funds.

Examine Sector Weightings: You must know that funds with large stakes in just one or

two sectors will likely be more volatile than the more evenly diversified funds. Looking

at a fund's sectoral history will help you gain a good perspective. Does the manager move

in and out of sectors frequently and dramatically? If so, the fund might get hurt, if the

manager is ever caught on the wrong foot.

Check out the Fund's Concentration: A portfolio with just 20 or 30 stocks or one that

puts most of its assets in just a few stocks will likely be more volatile than a fund that's

spread among hundreds of stocks. But there could be rewards of concentration. A

concentrated portfolio will also get more bangs for its buck if its stocks work out. You

may want to add a concentrated fund, one that owns fewer stocks or puts most of its

assets in the top 10 or 20 stocks, to your portfolio.

But largely, your core funds should probably be well a diversified and more predictable.

Though a small allocation to a sector-oriented fund, a more-flexible fund, or a more-

concentrated fund could boost your returns.


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Assess Performance Appropriately: Past performance is no indicator of future results.

Investors should commit this statutory quote from mutual fund prospectus,

advertisements and any other literature to memory. It should be recalled more readily

than your bank account number. It should be repeated anytime you consider sending

money to any fund with a 100 per cent three-month gain.

Why? Chances are that a few months of boom will be followed by bust, as it has

happened in 2000. All the ICE concentrated funds, which were topping the charts fell flat

on their face. There was just no escape when their NAVs started declining like nine pins.

What should an investor do? Do not concentrate your mutual fund portfolio or invest in a

concentrated fund. And, above all, don't focus on short-term returns. When choosing a

fund, look for above-average performance, quarter after quarter, year after year.

Know Your Portfolio: Look for areas that are over-represented and for those that are

lacking. For example, will your portfolio be overly concentrated in the large-cap equities

or too much in highly rewarding but wildly volatile infotech stocks? Will you be missing

investments in small-cap stocks?

Be A Disciplined Investor: After you've chosen some funds, stick with them. Don't be

afraid to go ahead.


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2. INTRODUCTION TO DERIVATIVES MARKET

2.1 Definition

Financial markets are, by nature, extremely volatile and hence the risk factor is an

important concern for financial agents. To reduce this risk, the concept of derivatives

comes into the picture. Derivatives are products whose values are derived from one or

more basic variables called bases. These bases can be underlying assets (for example

forex, equity, etc), bases or reference rates. For example, wheat farmers may wish to sell

their harvest at a future date to eliminate the risk of a change in prices by that date. The

transaction in this case would be the derivative, while the spot price of wheat would be

the underlying asset.

2.2 History

The history of derivatives can be traced to the Middle Ages when farmers and traders in

grains and other agricultural products used certain specific types of futures and forwards

to hedge, their risks. Essentially the farmer wants to ensure that he receives a reasonable

price for the grain that he would harvest [say] three to four months later. An oversupply

will hurt him badly. For the grain merchant, the opposite is true. A fall in the agricultural

production will push up the prices. It made sense therefore for both of them to fix a price

for the future. This was how the Futures market first developed in agricultural

commodities such as cotton, coffee, petroleum, soya bean, sugar and then to financial

products such at interest rates, foreign exchange and shares. In 1995 the Chicago Board

of Trade commenced trading in Derivatives.

Derivatives Market in India

In the Indian context the Securities Contracts (Regulation) Act, 1956 (SC(R)A) defines

derivative to include


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1. A security derived from a debt instrument, share, loan whether secured or unsecured,

risk instrument or contract for differences or any other form of security.

2. A contract which derives its value from the prices, or index of prices, of underlying

securities. Derivatives are securities under the SC(R)A and hence the trading of

derivatives is governed by the regulatory framework under the SC(R)A.

Equity derivatives trading started in India in June 2000, after a regulatory process which

stretched over more than four years. In July 2001, the equity spot market moved to

rolling settlement. Thus, in 2000 and 2001, the Indian equity market reached the logical

conclusion of the reforms program which began in 1994. It is hence important to learn

about the behavior of the equity market in this new regime.

Indias experience with the launch of equity derivatives market has been extremely

positive, by world standards. NSE is now one of the prominent exchanges, amongst all

emerging markets, in terms of equity derivatives turnover. There is an increasing sense

that the equity derivatives market is playing a major role in shaping price discovery.

Figure 4


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Risks

The risks associated with derivatives are very different to those incurred in the cash

markets. When buying a share for example - a long position - your maximum possible

loss is the amount you originally paid for it.

Derivatives, on the other hand, exhibit a lot of different risk profiles. Some provide

limited risk and unlimited upside potential. For example, the risk of loss with a derivative

contract, which confers a right to buy a particular asset at a particular price, is limited to

the amount you have paid to hold that right. However, profit potential is unlimited.

Others display risk characteristics in which while your potential gain is limited, your

losses are potentially unlimited. For example, if you sell a derivative contract which

confers the right to buy a particular asset at a particular price, your profit is limited to the

amount you receive for conferring that right, but, because you have to deliver that asset to

the counterparty at expiry of the contract, your potential loss is unlimited. Because of the

wide range of risk profiles which derivative contracts exhibit, it is vital that you have a

clear understanding of the risk/return characteristics of any derivative strategy before you

execute it.

Leverage

Apart from the structure of the instrument itself, the source of a lot of the risk associated

with derivative contracts stems from the fact that they are leveraged contracts.

Derivative products are said to be leveraged because only a proportion of their total

market exposure needs to be paid to open and maintain a position. This percentage of the

total is called a margin in futures markets; and a premium in options markets. In this

context, leverage is the word used in all English-speaking derivative markets.

Because of leverage your market exposure with derivative contracts can be several times

the cash you have placed on deposit as "margin" for the trade, or paid in the form of a

premium.


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Leverage, of course, can work both in your favour and against you. A derivative which

gives you a market exposure of 10 times the funds placed on deposit is excellent if prices

are moving in your favour, but not so good if they are moving against you, as losses will

mount up very rapidly.

Figure 5

In other words, with leveraged positions, losses are magnified as well as gains.

2.3 FUTURES

A futures contract is a contract to purchase a specific underlying instrument at a specific

time in the future, for a specific price. All futures are exchange-traded contracts and

they're standardized in terms of delivery date, amount and contract terms.

Traders use futures contracts to speculate on the direction of an underlying instrument

(including indices). Banks and other financial institutions use them to hedge their

portfolios against adverse fluctuations in the price of an underlying exposure. Such

hedging is possible because you can short futures contracts - i.e. sell the futures contract.

A futures contract is an agreement between a buyer or seller of the contract and a futures

exchange in which the buyer or seller agrees to take or make delivery of a specific

amount of a particular instrument or commodity, at a specific price, at a specified time.


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All futures are exchange traded contracts and they are standardized in terms of the

delivery date, the amount of the 'underlying' they relate to, and the contract terms. Futures

contracts can also be freely bought and sold before the contract expires.

When an investor buys a futures contract, the investor is said to be long the futures.

Buying (going long) a future commits you to buying the underlying at a future date.

Figure 6

If an investor sells a futures contract, they are said to be short the futures. Selling

(shorting) a future commits you to selling the underlying at a future date.

Figure 7

As we have already seen earlier, futures contracts are contracts to buy or sell a specific

underlying instrument at a specific time in the future, for a specific price.


Selling (shorting) a future commits you to selling the underlying at a future date.

All futures are exchange-traded contracts and they are standardised in terms of the

delivery date, the amount of the 'underlying' they relate to, and the contract terms. They

are also contracts with a limited lifespan - i.e. they expire after a certain date.


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Although futures contracts, if held till "delivery", lead to fulfillment of their

commitments, generally speaking, very few contracts are taken to delivery. Instead,

holders of futures positions will normally "close out" by selling the contract - thus

avoiding the prospect of having to make/take delivery of the underlying.

Margin and leverage

When clients wish to buy or sell a futures contract they instruct a broker, who will be a

member of the exchange where the futures contract is traded. The broker will then

instruct a market maker to execute the order on their behalf.

Unlike trading underlying markets, when you buy a futures contract, it doesnt involve

actually paying for the full market exposure of the contract you have bought. Rather, the

position is established at that price level. Profits or losses due to any subsequent price

changes are paid out or received on a day to day basis.

A small percentage of the overall contract exposure is deposited as "margin" when a

position is opened - so-called initial margin - and refunded on closing. The size of this

margin bears a relationship to the likely price movements as well as the size of the

position taken.

As long as the position is open this margin is marked-to-market on a daily basis.

Marking-to-market simply means that the size of the margin is adjusted to take account of

the end-of-day value of the open position. If the position has generated a profit this is

credited to the contract holder's account and, indeed, they may be able to withdraw

margin.


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Figure 8

If the position has generated a loss then the customer must deposit additional funds to

restore the margin to its initial level. This payment is called variation margin.

Figure 9

Apart from the small transaction cost per contract bought or sold, the initial and variation

margin are all that an investor has to put up to control a much larger amount. For this

reason, futures contracts, like other derivatives contracts, provide leverage.


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2.3.1 PARTICIPANTS IN THE FUTURES MARKET

There are three kinds of participants in the Futures market. Lets discuss each one of them

in detail

Hedgers

Speculators and

Arbitrageurs

All three must co-exist. A Hedger is risk averse. Typically in India he may be a Treasurer

in a public sector company who wants to know with certainty his interest costs for the

year 2002. Therefore based on current information he would enter into a futures contract

and lock up his interest rate four years hence. But in doing so he consciously ignores

what is called the upside potential - here the possibility that the interest rate may be lower

in the year 2002 than what he had contracted four years earlier. A Hedger therefore plays

it safe. For a hedging transaction to be completed there must be another person willing to

take advantage of the price movements. That is the Speculator.

Contrary to the Hedger who avoids uncertainties the Speculator thrives on them. The

speculator may lose plenty of money if his forecast goes wrong but stands to gain

enormously if he is proved correct. The risk taking associated with speculation is an

integral part of a Derivative market. The third category of participant is the Arbitrageur,

who looks at risk less profit by simultaneously buying and selling the same or similar

financial products in different markets. Markets are seldom perfect and there is a

possibility to take advantage of time or space differentials that exist. Arbitrage evens out

the price variations.


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HEDGING

Suppose you have a position in a cash market, which you want to maintain for whatever

reason it may be difficult to sell, or perhaps it forms part of your long-term portfolio.

However, you anticipate an adverse movement in its price. With a derivatives hedge it is

possible to protect these assets from the fall in value you fear. Lets see how.

As we have already said, the value of a derivative contract is related to the value of the

underlying asset it relates to. Because of this, with derivatives, it is possible to establish a

position (with the same exposure in terms of the value of the contract), which will

fluctuate in value almost in parallel with an equivalent underlying position.

It is also possible with derivative contracts to go long or short; in other words you can

take an opposite position to the position you have in a particular underlying asset (or

portfolio).

Hedging involves taking a temporary position in a derivatives contract(s), which is equal

and opposite to your cash market position in order to protect the cash position against

loss due to price fluctuations. As the price moves, loss is made on the underlying, whilst

profit is made on the derivative position, the two canceling each other out.

Protecting assets, which you hold from a fall in value by selling an equivalent number of

derivative contracts, is known as a short hedge.

A futures contract is an agreement between a buyer or seller of the contract and a futures

exchange in which the buyer or seller agrees to take or make delivery of a specific

amount of a particular instrument or commodity, at a specific price, at a specified time.

All futures are exchange traded contracts and they are standardized in terms of the

delivery date, the amount of the 'underlying' they relate to, and the contract terms. Futures

contracts can also be freely bought and sold before the contract expires.


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When an investor buys a futures contract, the investor is said to be long the futures.


A long hedge, on the other hand, involves buying derivatives as a temporary substitute

for buying the underlying at some future point. This is to lock in a buying price. In other

words, you are protecting yourself against an increase in the underlying price between

now and when you buy in the future.

Cash and derivatives markets move together more or less in parallel, but not always at the

same time, or to the same extent. This introduces a certain amount of what is called hedge

inefficiency, which may need to be adjusted. At other times, an imperfect hedge might be

knowingly established, which leaves a small exposure to the underlying market

depending on the risk appetite of the individual.

Hedging: Long security, short Nifty futures

Investors studying the market often come across a security which they believe is

intrinsically undervalued. It may be the case that the profits and the quality of the

company make it seem worth a lot more than what the market thinks. A stock picker

carefully purchases securities based on a sense that they are worth more than the market

rise. When doing so, he faces two kinds of risks:

1. His understanding can be wrong, and the company is really not worth more than the

market price; or,

2. The entire market moves against him and generates losses even though the underlying

idea was correct.

However, there is a simple way out. Every time you adopt a long position on a security,

you should sell some amount of Nifty futures. This offsets the hidden Nifty exposure that

is inside every longsecurity position.


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Hedging: Short security, long Nifty futures

Investors studying the market often come across a security which they believe is

intrinsically over-valued. It may be the case that the profits and the quality of the

company make it worth a lot less than what the market thinks. A stock picker carefully

sells securities based on a sense that they are worth less than the market price. In doing so

he faces two kinds of risks:

1. His understanding can be wrong, and the company is really worth more than the

market price; or,

2. The entire market moves against him and generates losses even though the underlying

idea was correct.

Every time you adopt a short position on a security, you should buy some amount of

Nifty futures. This offsets the hidden Nifty exposure that is inside every shortsecurity

position. Once this is done, you will have a position which is purely about the

performance of the security.

SPECULATION

Speculation is a strategy in which a position is taken on the future movement in the prices

of the shares. Previously mutual funds were not permitted to speculate in the derivatives

market. They were allowed to use derivatives only for the purpose of hedging. But with

the recent amendment in the regulations by Sebi, mutual funds can also use the

opportunity of speculating in derivatives.

A fund manger may have a view that markets are going to rise and that he can benefit by

taking a position on the index. Based on his view, he can buy Nifty futures and hold on to

that position until the price rises to his expected level. If the fund manager's view about

the market proves to be correct (i.e. the market rises), the fund will make a profit on its

Nifty future position.


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On the contrary, if his view proves incorrect then the fund will end up making a loss.

Conversely, if a fund manager feels bearish about the market, he will sell Nifty futures

and will hold on to it until the markets moved southwards. Similarly, the fund manager

can also speculate in individual stocks by buying or selling stock futures/options

Speculation in derivatives is a double-edged sword, i.e. there exists a possibility of

making profits or incurring losses based on how the fund manager's call pans out.

Speculation can be done on both futures and options (Call & Put).

Though futures have potentially unlimited upside and downside, the payoff for options is

a bit unique. For the buyer of the option, the loss is limited to the premium whereas for

the seller it is unlimited.

ARBITRAGE

Arbitrage is a strategy, which involves simultaneous purchase and sale of identical or

equivalent instruments in two or more markets in order to benefit from a discrepancy in

pricing. This strategy normally acts as a shield against market volatility as the buying and

selling transactions offset each other.

Recently UTI Mutual Fund and JM Mutual Fund have launched arbitrage funds, which

will employ the arbitrage strategy of buying in cash and simultaneously selling in futures

market.

In an arbitrage transaction, returns are calculated as the difference between the futures

price and cash price at the time of the transaction. Ideally the positions are held till the

expiry of the futures contract when the offsetting positions cancel each other and initial

price difference is realised.

This arbitrage strategy makes the fund immune to market volatility i.e. the fund will not

be affected by market fluctuations. Since the portfolio of arbitrage funds is completely

hedged at all times to lower the risk of loss/erosion of gains, it also in turn caps the


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returns that the fund could have clocked if the portfolio was unhedged i.e. these funds

have a limited upside.

Despite the fact that arbitrage funds offer investors the opportunity to benefit from

investments in equities by making use of derivatives, the fund cannot be compared to

conventional diversified equity funds, especially on the returns parameter.

The returns from arbitrage funds would typically be much lower than those of equity

funds. That could be one reason why despite their equity holdings, arbitrage funds are

benchmarked against indices like CRISIL Liquid Fund Index for want of a more

appropriate index.

Apart from the strategies mentioned here, there are more complex derivative strategies,

which can be used by mutual funds. The strategy would depend mainly on the prevailing

market condition.

From the investor's perspective, investing in a mutual fund that dabbles in derivatives

should not be considered as a sure shot way to generate/enhance returns.

While hedging and arbitrage strategies, when used effectively, can make the fund's

portfolio immune to market volatility, using derivatives for speculation holds the

possibility of converting the fund into a typical high risk -- high return investment

proposition.

2.4. OPTIONS

An option is a contractual agreement that gives the holder the right to buy (call option) or

sell (put option) a fixed quantity of a security or commodity (for example, a commodity

or commodity futures contract), at a fixed price, within a specified period of time. May

either be standardized, exchange-traded, and government regulated, or over-the-counter

customized and non-regulated.


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The seller of the option grants the buyer of the option the right to purchase from, or sell

to, the seller a designated instrument at specified price within a specified period of time.

If the option buyer exercises that right, the option seller is obligated.

The seller (known as the writer) grants this right to the buyer in exchange for a sum of

money called the option premium. The option premium is effectively the price of the

option.

The price at which the underlying instrument may be bought or sold is called the exercise

or strike price. The date after which the option is no longer active is called the expiration

date. In India we follow European-style option .Here the option may be exercised only

on the expiration date.

Call Options: Profit and loss

If you buy an options contract you are buying the option, or "right" to trade a particular

underlying instrument at a stated price.

An option that gives you the right to eventually make a purchase at a predetermined price

is called a "call" option. If you buy that right it is called a long call; if you sell that right it

is called a short call. An option that gives you the right to eventually make a sale at a

predetermined price is called a "put" option. If you buy that right it is called a long put; if

you sell that right it is called a short put.

A profit/loss graph shows, as the name suggests, the potential profit and loss inherent in a

particular option position. We will start with call options. Suppose a call option with an

exercise/strike price equal to the price of the underlying (100) is bought today for Rs1.

At expiry, if the securitys price has fallen below the strike price, the option will be

allowed to expire worthless and the position has lost Rs1. This is the maximum amount

that you can lose because an option only involves the right to buy or sell, not the

obligation. In other words, if it is not in your interest to exercise the option you dont

have to and so if you are an option buyer your maximum loss is the premium you

have paid for the right.


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3. HEDGING MUTUAL FUNDS

3.1. Hedging

What is Hedging :

Hedging is a mechanism to reduce price risk inherent in open positions. Derivatives are

widely used for hedging. A Hedge can help lock in existing profits. Its purpose is to

reduce the volatility of a portfolio, by reducing the risk. It needs to be noted that

hedging does not mean maximization of return. It only means reduction in variation of

return. It is quite possible that the return is higher in the absence of the hedge, but so also

is the possibility of a much lower return.

It is the responsibility of the portfolio managers to reduce their exposure of risks, if there

is any fall in the price. This can be done in several ways. Simply selling the stock and

repurchasing it late is one way. But this strategy involves substantial costs. It is relatively

expensive to buy and sell stock because of the transaction costs in the form of bid-ask

spreads and commissions. Again trading in large amount of stock can influence the

market, resulting in poor realization of prices.

There is other alternative to solve this issue, which is called hedging. Hedging with

futures basically involves taking a position in futures as a temporary alternative for

transactions to be executed in the cash market. The primary objective of hedging is to

avoid price risk by trying to fix the price of the transaction to be made at a later date. If

cash and future prices move together, any loss realized in one market will be

compensated by the profit in other markets. When the profit and loss from each position

are equal, the hedge is said to be perfect.

The liquidity of stock index futures has made them the markets choice especially for

institutional investors. When using stock index futures to reduce stock market risk, the

anticipation is that any losses arising from movements in stock prices are offset by gains

from parallel movement in future prices.


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A portfolio manager might be worried about the possibility that the decline in the value

of the portfolio by taking position in the future market that would provide a gain in the

event of a fall in stock prices. In such a case, the short position, fund manager ensures a

notional selling price of a quantity of stock for a specific date in future. Should stock

prices fall and stock index futures behave in a corresponding manner, the notional buying

price on that date would be less than his/her position in futures by taking a long position

in the same number of the contracts. The excess of selling price over the buying price is

paid out to the portfolio manager.

On the other hand, if the stock prices had increased, then the portfolio manager would

have gained from his/her portfolios of equities but lost on future dealings. In either case,

the portfolio manager would have succeeded in reducing the extent to which the value of

the portfolio fluctuates. The major advantage in using index futures is to hedge the risk of

a fall in the stock prices without any alteration in the original portfolio.

Let us work out an example to understand this concept. Fund manager holds a balanced

portfolio of equities valued at Rs. 1,00,00,000 on April 5, but fears a fall in its value due

to general fall in equity prices. Assume that the benchmark index on which futures are

being traded is at 500 and futures contracts trade at multiple of 500 times the index and

so to hedge the portfolio the fund manager has to sell 40 June contracts at a price of 500

each. He has thus committed himself to the notional sale of Rs.1.00.00.000 of the stock

on the June delivery date at the level of equity prices implied by the futures on April 5,

(40 x 500 x 500 = Rs. 1,00,00,000).

In a practical situation, hedging may not be as perfect as above because the amount of the

loss and profit from each position may not be equal. The real outcome of a hedge will

depend on the relationship between the cash price and futures price when hedge is

entered into and when it is squared off.

The difference between the cash price and future price is called the basis. The risk that

the change in basis will not be favorable is known as basis risk. In most of hedging

applications, the asset to be hedged is not identical to the asset underlying the future


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contract. This type of hedging is referred as cross hedging in which the characteristics of

the spot and future position do not match perfectly. In this type of hedging one can expect

a lot of exposure to the basis risk. An unhedged position in any asset is exposed to price

risk, while a hedged position replaces the price risk with basis risk.

In the case of declining cash price of fixed income securities resulting form the increase

in the interest rate, futures on fixed instruments should be sold (short). The hedged

position can fix the cash price to be realized later and can also transfer the price risk of

ownership to the buyer of the futures contract. Considering that the effectiveness of the

hedge depends on the movement of basis, it is possible to assess the size of position to be

taken in futures so as to minimize the impact of basis risk if not to eliminate it.

On the other hand, to protect against an increase in cash price of the fixed income

instrument resulting from the decline in interest rate, futures on that fixed income security

should be purchased (long hedge). By establishing a long hedge, the hedger is locking in

a purchaser price. A long hedge will be used when substantial cash contribution is

expected and investor will expect interest rate to decline. Again to lock in the interest

rate, long hedge can be used when the bonds are maturing in near future and interest rates

are expected to fall.

General Hedging Strategies

One of the popular strategies for hedging is : "If you are long in cash underlying - Short

Future; and If short in cash underlying - Long Future".

This can be illustrated by a simple example. If one has bought 100 shares of say Reliance

Industries and want to Hedge against market movements, he has to short an appropriate

amount of Index Futures. This will reduce his overall exposure to events affecting the

whole market (systematic risk).


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Suppose a major terrorist attack takes place, the entire market can sharply fall. In such a

case, his in Reliance Industries would be offset by the gains in his short position in Index

Futures.

Some other examples of where hedging strategies that can be really useful can be as

follows :-

Reducing the equity exposure of a Mutual Fund by selling Index Futures;

Investing funds raised by new schemes in Index Futures so that market

exposure is immediately taken; and

Partial liquidation of portfolio by selling the index future instead of the actual

shares where the cost of transaction is higher

3.2. Activities of Fund-Houses

We had already seen the applicability of index futures in portfolio, but fund-houses are

not very keen in using strategy. Generally, fund-houses are not concerned about the

short-term fluctuations, as they are more concerned about long-term objectives and in the

NAVs. However, retail investors are typically short sighted in their investment

objectives. A fund that has performed well in the last couple of months is perceived as

one that will do just as well in the future. Hence, portfolio manager would tend to invest a

proportion of the portfolio in momentum stocks that are expected to increase sharply in

the near term. Further, to continue, the fund should construct appropriate hedging

strategy to ensure that the portfolio is not affected in the short-term.

For instance, a fund may choose to hedge only 50 per cent of its total portfolio or to

hedge only the stocks that are considered momentum plays. This could entail

differentiating the assets into trading and investment portfolio. However, portfolio

managers do not seem to have a hedging strategy in their portfolios, as they do not have a

position in the derivatives market.


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Although, portfolio managers use value-at-risk models to control risk is not the same as

hedging. Such risk models attempt to control the portfolio risk by managing the exposure

in the spot market. Hedging, on the other hand, refers to taking a derivatives position that

is contrary to the one in the spot market.

Further, SEBI has clarified that mutual funds are permitted to hedge by taking positions

contrary to their exposure in the spot market. Fund-houses are not in apposition to

defend themselves by stating that the investment objectives do not provide for such

hedging. Most funds that were started way before derivatives trading was introduced in

India now have unit-holders' approval to construct a hedging programme.

3.2.1. What kind of risk needs to be hedged?

If a mutual fund holds substantial shares of that company's stock, it may have to consider

hedging its position against such an event risk. The reason behind this is the stock may

have sparkled up in anticipation of a favorable verdict from the USFDA. On the other

hand, if the ruling is adverse, the stock may experience a steep decline in its value. Thus,

portfolio management demands that mutual funds construct a hedging system to reduce

short-term decline in NAVs. This would emphasize the need to construct the portfolio in

the backdrop of a short-term and long-term risk-return matrix.

3.3. Risk Management and the Mutual Funds

The objective of a mutual fund is to provide a diversified portfolio that reduces the risk in

investments at a lower cost. Investors who take up mutual fund route for investments

believe that their risk is minimized at lower costs, and they get an optimum portfolio of

securities that match their risk appetite. However, investors are ignorant about the diverse

techniques and hedging products that can be used for minimizing the market volatility

and hence take the help of the fund managers.

In some cases, the drop in NAV of some of the schemes is higher than the decline of

value in some of the Information, Communication and Entertainment stocks. The recent


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survey conducted by PricewaterhouseCoopers (PWC) on risk management by mutual

funds has posted some interesting as well as worrying results. According to the survey

published by PWC, 50 percent of the respondent mutual funds are not managing risk

properly and remaining 50 percent of the respondents did not even have documented risk

procedures or dedicated risk managers. The respondents included among others are some

of the heavyweights of the Indian MF industry viz. Templeton, Alliance, Prudential and

IDBI Principal MF.

The recent volatile movements in the NAVs of several equity funds have disproved all

expectation of a diversified portfolio from the fund managers when the basic tenet behind

portfolio management is risk management. Further, no fund managers are trying to use

derivatives in their portfolio and this is clearly visible from the following statement.

3.4. Hedging minimizes the risk of portfolio

There are times when an investor should consider re-balancing portfolio to minimize risk.

When the stock market is particularly volatile, or when an investor is nearing retirement,

it becomes more important to protect assets than to go for risky growth . The objective of

hedging is to reduce the risk of the extent to which the portfolio is exposed. The risk is

reduced by making an additional investment, whose risk cancels out the initial risk. Let

us understand this with an example, a mutual fund manager holds assets worth Rs. 50

crores. Fund Manager feels that the market is in highly volatile condition and it might

drop in near future, so to protect his fund, he could uses the following strategies


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Liquidate a portion of the assets and hold cash

Sell index futures equal to the value of the portfolio

In the latter case, the benefit of using index futures becomes apparent. Using the first

strategy means the portfolio manager has to liquidate a portion of his assets. Normally, as

the risk is greater in a falling market, his ability to get a good price when selling is

remote. Normally, in such circumstances, the fund manager is forced to sell some of his

premium holdings. For instance, the UTI, which had to sell large volumes of Hindustan

Lever and ITC to meet dividend payments under the US-64.

Further, all the stocks in the portfolio may be solid ones, which would generate excess

returns over the long term. On the other hand, by using index futures, the fund manager

can avoid the need to sell individual stocks. At the same time, he can cover the value of

the portfolio against any adverse movement in prices.

Making the perfect hedge, where the manager can completely cover his market risk, is

important as the portfolio gets strengthened. But this may not be a good strategy as it will

generate only the risk-free rate of return. Traditional capital market theory states that

investors are rewarded for the market risk component in their portfolios.

By executing a perfect hedge, market risk is completely eliminated, thereby not earning

excess return. However, in practice, finding a perfect hedge is not a possible. An

important characteristic of a perfect hedge is that the movement of the portfolio must be

perfectly correlated with the movement of the underlying index.

Uses of index futures

Fund managers can use index futures in these ways:

Portfolio performance can be segregated into two portions based on stock selection and

market timing. Stock selection relates to the ability of the fund manager to spot stocks

that are mispriced, while market timing is concerned with his ability to forecast market


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movements. Let us envisage a situation where a fund manager identifies a share that is

underpriced but has a high beta value.

Assuming that the market may fall, the fund manager is in a fix. From the point of view

of stock selection the decision warrants going long on the stock but market timing

suggests otherwise. This is where the use of index futures to control beta plays a crucial

role. Effectively, index futures permit control of the riskiness of the portfolio without

hindering the stock selection decision.

Another important aspect where index futures help is in asset allocation. Returns for a

fund depend on the right level of diversification and the choice of assets used to diversify.

If there arises a situation where the asset manager is able to identify a different set of

assets which would improve the fund's performance, what should he do?

He has two options: The first is to liquidate the existing asset position and the next is to

purchase a new set of assets. As such a process requires time, managers can immediately

lock in on the returns by using corresponding futures contracts.

With uncertain volatility, funds face problems in terms of redemptions. In the absence on

index futures, funds have to invest the money in short-term deposits and other highly

liquid instruments. However, the return earned on such assets is lower than those on

equity investments. With the introduction of futures, fund managers have a highly liquid

option, providing a higher rate of return, in which they can invest their excess funds.

The role of foreign institutional investors in the Indian market has been

critical in the recent past. The introduction of index futures as a hedging mechanism may

actually attract more foreign funds into the country by way of FII investments. An

investor who invests in foreign markets is exposed to two sources of risk -- market risk

and the foreign exchange risk associated with the country.

When the position is liquidated, the proceeds are converted to the home currency of the

international investor at the prevailing exchange rate. By taking an opposite position in

the futures market, the investor's risks are confined to margin payments and receipts

which would be much lower than the actual position in the stocks.


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4. REGULATORY FRAMEWORK

Use of derivatives by mutual funds

Mutual funds should be allowed to use financial derivatives for hedging purposes

(including anticipated hedging) and portfolio re-balancing within a policy framework and

rules laid down by their Board of Trustees who should specify what derivatives are

allowed to be used, within what limits, for what purposes, for which schemes, and also

the authorisation procedure.

The offer documents of mutual fund schemes should disclose whether the scheme

permits the use of derivatives and the details in this regard. Also the income and.32

balance sheet of each mutual fund scheme would have to disclose the impact of

derivatives trading and of any open position in this regard.

New Schemes: Utilising mainstream governance and disclosure mechanisms

Under normal circumstances, the trading strategies and ideas in portfolio management

used by the AMC should be fully disclosed in the offer document, and the AMC should

be closely interacting with the trustees who perform governance functions on behalf of

investors on all aspects of the operations of the scheme. In this environment, the role of

SEBI is limited to certain improvements in disclosure norms, using which mutual funds

would give investors and potential investors sound information about the portfolio

strategies associated with a given scheme.

Hence, the first mechanism through which mutual fund schemes can engage in

derivatives trading consists of three steps:

Additional text in the prospectus which fully explains the ways in a given scheme would

use financial derivatives, including numerical examples,

An ongoing dialogue with the trustees, whereby the trustees would establish that the

actual functioning of the AMC is consistent with these promises,


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By these principles, if a mutual fund house can persuade investors that a beta=5

leveraged equity index fund is an attractive product, and thus raise resources which

should be deployed through such a strategy, then it should be free to implement this using

index futures and/or index options.

This path can be utilised when new schemes are created. For existing mutual fund

schemes, utilising this path involves a modification to the offer document, which entails

obtaining the consent of existing unit-holders.

Existing Schemes: Rules governing hedging and portfolio rebalancing.

The bulk of mutual fund assets today are in existing open-end schemes. It is likely that

the bulk of new resources coming into mutual funds in the future will come into open-end

schemes that exist as of today. In the absence of any changes to a mutual fund prospectus,

the rules governing derivatives trading by mutual funds should limit mutual funds to

certain strategies:

Portfolio rebalancing

Hedging

6.2.1 What does hedging mean?

The term hedging is fairly clear. It would cover derivative market positions that are

designed to offset the potential losses from existing cash market positions. Some

examples of this are as follows:

An income fund has a large portfolio of bonds. This portfolio stands to make losses when

interest rates go up. Hence, the fund may choose to short an interest rate futures product

in order to offset this loss.


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An income fund has a large portfolio of corporate bonds. This portfolio stands to make

losses when credit spreads of these bonds degrade or when defaults take place. Hence, the

fund may choose to buy credit derivatives which pay when these events happen.

Every equity portfolio has exposure to the market index. Hence, the fund may choose to

sell index futures, or buy index put options, in order to reduce the losses that would take

place in the event that the market index drops.

The regulatory concerns are about (a) the effectiveness of the hedge and (b) its size.

Hedging a Rs.1 billion equity portfolio with an average beta of 1.1 with a Rs. 1.3

billion short position in index futures is not an acceptable hedge because the over hedged

position is equivalent to a naked short position in the future of Rs. 0.2 billion. Similarly,

hedging a diversified equity portfolio with an equal short position in a narrow sectoral

index would not be acceptable because of the concern on effectiveness. A hedge of only

that part of the portfolio that is invested in stocks belonging to the same sector of the

sectoral index by an equal short position in the sectoral index futures would be

acceptable.

Hedging an investment in a stock with a short position in another stocks futures is not

an acceptable hedge because of effectiveness concerns. This would be true even for

merger arbitrage where long and short positions in two merging companies are combined

to benefit from deviations of market prices from the swap ratio.

Hedging with options would be regarded as over-hedging if the notional value of the

hedge exceeds the underlying position of the fund even if the option delta is less than the

underlying position. For example, a Rs.2 billion index put purchased at the money is not

an acceptable hedge of a Rs.1 billion, beta=1.1 fund though the option delta of

approximately Rs. 1 billion is less than the underlying exposure of the fund of Rs. 1.1

billion.


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Covered call writing is hedging if the effectiveness and size conditions are met. Again the

size of the hedge in terms of notional value and not option delta must not exceed the

underlying portfolio.

The position is more complicated if the option position includes long calls or short puts.

The worst-case short exposure considering all possible expiration prices (see 6.2.3 below)

should meet the size condition.


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5. DATA ANALYSIS AND PRESENTATION

The purpose of this study is to understand and identify the effectiveness of using

derivatives in the Mutual Funds. For this purpose, I have taken Franklin Templeton

Investments in the Mutual category and S&P CNX Nifty, CNX IT in the F&O segment.

Further, this study is done for the period between May 2, 2008 and May 24, 2008. The

basic reason behind choosing this period is to identify the effectives of hedging in the

short term horizon. I have taken three equity related schemes for the study and they are as

follows

1. Franklin Bluechip Fund Growth

2. Franklin Infotech Fund Growth

3. Franklin India Prima Fund Growth


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5.1. Franklin Bluechip Fund

Investment Objective: The objective of this fund is to maintain the steady and consistent

growth by focusing on well-established and large size companies. Further, the fund aims

to provide medium to long term capital appreciation.

*Portfolio composition is as of APRIL 30, 2008


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STEP 1:

Calculation of market lots to be sold in the futures market:

Ascertain of Market Lot

in millions

Total Asset Value (April 30, 2008) 23681

Beta 1

Complete Hedge 23681

50% Hedge 11840.5

Nifty on 2-May 3595

Market lot 100

Cost of 1 ML 359500

1 0.3595? 11840.5

Total Market Lot 32936.02

NAV on April 30, 2008:

NAV Total Units (in millions)

117.36 201.7808453

To have 50% Hedge, the fund manager has to sell 32,936 nifty futures

*Note: NAV means Net Asset Value

STEP 2:

Calculation of mutual fund returns

No of Units: 201.78


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Date Total Assets

(in millions)

NAV Daily Returns

2-May-08 24431.62 121.08

3-May-08 24480.05 121.32 0.198

4-May-08 24643.49 122.13 0.668

5-May-08 24695.96 122.39 0.213

8-May-08 24708.05 122.44 0.041

9-May-08 24829.13 123.05 0.498

10-May-08 24887.65 123.34 0.236

11-May-08 24625.33 122.04 -1.054

12-May-08 24429.61 121.07 -0.795

15-May-08 23495.36 116.44 -3.824

16-May-08 23475.18 116.34 -0.086

17-May-08 23878.75 118.34 1.719

18-May-08 22431.98 111.17 -6.059

19-May-08 21628.89 107.19 -3.58022-May-08 20589.72 102.04 -4.805

23-May-08 21318.15 105.65 3.538

24-May-08 20878.26 103.47 -2.083

Returns for the period -14.544

Interpretation for steps 1 and 2:

The first and foremost step is to identify the number of market lots to be sold in the

futures market. For this purpose, we require the total asset value of the portfolio. As the

study is done for the period between May 1, 2008 and May 24*, 2008, the TAV on May

2 will be equivalent to closing TAV of April 2008. After finding the TAV, fund manager

has to decide the proportion to hedge and this is not constant for all the schemes, as the

risks are suppose to vary according to the nature of the scheme. In this case I have

assumed to hedge 50% of the TAV and calculated the number of market lots accordingly.

The result was to short 32,936 futures contract.


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In the next step, I have calculated the mutual fund returns for both daily and for the

period. The above calculated unhedged mutual fund returns yielded the negative returns

of 14.5%. If the fund manager had used the futures market to hedge the mutual fund

returns, he could have minimized the risk. Lets us see an example of the same scheme,

which used the hedging strategy.

*The futures contract expiry date was May 25, 2008 and that was the reason for selecting

May 24, 2008 as a closing date, thus allows the fund manager to offset his position.


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STEP: 3

Short 32, 936 nifty futures on May 2, 2008

Date Nifty futures Difference Market

Lot

Profit/Loss

(in millions)

32,936

2-May-08 3595

3-May-08 3612.4 17.4 -57.31

4-May-08 3627.4 15 -49.40

5-May-08 3644.1 16.7 -55.00

8-May-08 3685.85 41.75 -137.51

9-May-08 3712.95 27.1 -89.26

10-May-08 3745.4 32.45 -108.88

11-May-08 3692.9 -52.5 172.91

12-May-08 3633 -59.9 197.29

15-May-08 3462.05 -170.95 563.04

16-May-08 3520.3 58.25 -191.85

17-May-08 3641.25 120.95 -398.36

18-May-08 3363.85 -277.4 913.64

19-May-08 3224.35 -139.5 459.46

22-May-08 3020.9 -203.45 670.08

23-May-08 3190.5 169.6 -558.59

24-May-08 3087.25 -103.25 340.08


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Interpretation for step 3:

Fund manager entered the futures market to minimize the portfolio risks. As per the

strategy, if you long portfolio, then short index futures. In this case, the schemes

underlying index is S&P CNX Nifty. So the fund manager has to short a certain number

of contracts to cover his portfolio risks. As per assumption, fund manager has gone 50%

hedge with portfolio beta of 1, therefore the total asset value multiplied by beta value to

give hedging proportion. Then the difference was calculated for the day to days

movements to find out the profit or loss for the transaction.

STEP 4:

Adjustment of futures contract profit or loss in mutual funds TAV to ascertain the

adjusted NAV


In this step, before adjusting the total profit or loss in TAV, it is necessary to ascertain the

daily difference in TAV, which has been calculated with the help of multiplying numberof units with daily NAV. Then the ascertained difference in TAV was adjusted with

profit or loss in the futures contract to find out the adjusted TAV.


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Date TAV

(in millions)

Difference

in TAV

P/L* in futures

contract

(in millions)

Total P/L Adjusted

TAV

2-May-08 24431.62 24431.62

3-May-08 24480.05 48.43 57.31 -8.88 24422.744-May-08 24643.49 163.44 49.40 114.04 24536.78

5-May-08 24695.96 52.46 55.00 -2.54 24534.24

8-May-08 24708.05 10.09 137.51 -127.42 24408.82

9-May-08 24829.13 123.09 89.26 33.83 24440.65

10-May-08 24887.65 58.52 108.88 -48.36 24392.29

11-May-08 24625.33 -262.32 -172.91 -89.40 24302.89

12-May-08 24429.61 -195.73 -197.29 1.56 24304.45

15-May-08 23495.36 -934.25 -563.04 -371.20 23933.25

16-May-08 23475.18 -20.18 191.85 -212.03 23721.22

17-May-08 23878.75 403.56 398.36 5.20 23726.42

18-May-08 22431.98 -1446.77 -913.64 -533.12 23193.2919-May-08 21628.89 -803.09 -459.46 -343.63 22849.66

22-May-08 20589.72 -1039.17 -670.08 -369.09 22480.57

23-May-08 21318.15 728.43 558.59 169.83 22650.41

24-May-08 20878.26 -439.88 -340.08 -99.82 22550.59

*Note: P/L denotes profit or loss


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STEP 5:

Calculation of adjusted NAV and ascertainment of hedged returns

Date Adjusted TAV NAV Hedged daily

returns

2-May-08 24431.62 121.08

3-May-08 24422.74 121.036 -0.036

4-May-08 24536.78 121.6011 0.467

5-May-08 24534.24 121.5886 -0.010

8-May-08 24408.82 120.9571 -0.519

9-May-08 24440.65 121.1247 0.139

10-May-08 24392.29 120.8851 -0.198

11-May-08 24302.89 120.442 -0.36712-May-08 24304.45 120.4497 0.008

15-May-08 23933.25 118.6101 -1.527

16-May-08 23721.22 117.5593 -0.886

17-May-08 23726.42 117.5851 0.022

18-May-08 23193.29 114.943 -2.247

19-May-08 22849.66 113.24 -1.482

22-May-08 22480.57 111.4108 -1.615

23-May-08 22650.41 112.2525 0.755

24-May-08 22550.59 111.7578 -0.441

Returns for the period -7.70

Graphical representation of hedged and unhedged returns:


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*Note: H-NAVr means Hedged returns (Daily)


In this step, we ascertained the hedged daily returns, which came to -7.70%. this clearly

shows the effectiveness of hedging. The unhedged mutual fund yielded the negative

return of -14.54%. Therefore, with the use of hedging strategy, fund manager can reduce

their risk exposure and in the above case around 50% of the market risk was eliminated

with the help of hedging. Additionally, the above chart depicts the reduction in risk,

which is compared with the unhedged ones. However, on May 23, 2008, unhedged

returns were high but in a overall scenario, hedging proved to be more effective.

Lovely Professional University

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Chi-Square Test

Null Hypothesis: Mutual Funds Returns = Hedge Funds Returns

Alternative Hypothesis: Mutual Funds Returns not equal to Hedge Funds Returns

Mutual Funds Hedge Funds

Returns Returns

0.198 -0.036

0.668 0.467

0.213 -0.010

0.041 -0.5190.498 0.139

0.236 -0.198

-1.054 -0.367

-0.795 0.008

-3.824 -1.527

-0.086 -0.886

1.719 0.022

-6.059 -2.247

-3.580 -1.482

-4.805 -1.6153.538 0.755

-2.083 -0.441

Result: By using Chi-square test, the Value of x square is 7.58 that are more than table

value i.e. 6.262 @ 5 % significance level. So Null Hypothesis is rejected it means the

hedging funds returns are not equal to mutual funds returns

5.2. Franklin Infotech Fund

Investment Objective: The objective is to focus on companies in the information

technology sector and to provide long term capital appreciation by investing primarily in

Information Technology industry.


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* Portfolio Composition as of April 30, 2008

STEP 1:

Calculation of market lots to be sold in the futures market:

Ascertainment of Market Lot

in millions


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Total Asset Value (April 30, 2008) 1602.4

Beta 0.88

Complete Hedge 1410.112

50% Hedge 705.056

Nifty on 2-May 4373.2Market lot 100

Cost of 1 ML 437320

1 0.43732

? 705.056

Total Market Lot 1612.22

NAV on April 30, 2008:

NAV Total Units (in millions)41.68 38.45

To have 50% Hedge, the fund manager has to sell 1,612 nifty futures

*Note: NAV means Net Asset Value


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STEP 2:

Calculation of mutual fund returns

Number of Units: 38.45 (in millions)


Date TAV

(in millions)

NAV Daily

Returns

2-May-08 1618.16 42.09

3-May-08 1633.93 42.5 0.974

4-May-08 1643.92 42.76 0.612

5-May-08 1639.69 42.65 -0.257

8-May-08 1649.30 42.9 0.586

9-May-08 1652.38 42.98 0.186

10-May-08 1661.61 43.22 0.55811-May-08 1648.15 42.87 -0.810

12-May-08 1638.92 42.63 -0.560

15-May-08 1597.02 41.54 -2.557

16-May-08 1593.56 41.45 -0.217

17-May-08 1625.85 42.29 2.027

18-May-08 1543.58 40.15 -5.080

19-May-08 1491.29 38.79 -3.387

22-May-08 1422.48 37 -4.615

23-May-08 1468.23 38.19 3.216

24-May-08 1445.93 37.61 -1.519

Monthly Returns -10.64

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Interpretation for steps 1 and 2:

The first and foremost step is to identify the number of market lots to be sold in the

futures market. For this purpose, we require the total asset value of the portfolio. As the

study is done for the period between May 1, 2008 and May 24*, 2008, the TAV on May

2 will be equivalent to closing TAV of April 2008. After finding the TAV, fund manager

has to decide the proportion to hedge and this is not constant for all the schemes, as the

risks are suppose to vary according to the nature of the scheme. In this case I have

assumed to hedge 50% of the TAV and calculated the number of market lots accordingly.

The result was to short 1,612 futures contract.

In the next step, I have calculated the mutual fund returns for both daily and for the

period. The above calculated unhedged mutual fund returns yielded the negative returns

of -10.64%. If the fund manager had used the futures market to hedge the mutual fund

returns, he could have minimized the risk. Lets us see an example of the same scheme,

which used the hedging strategy.

* The futures contract expiry date was May 25, 2008 and that was the reason for selecting

May 24, 2008 as a closing date, thus allows the fund manager to offset his position.


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STEP: 3

Short 1,612 CNX IT futures on May 2, 2008

Date CNX IT futures Difference MarketLot

Profit/Loss(in millions)

1,612

2-May-08 4373.2

3-May-08 4410.75 37.55 6.05

4-May-08 4413 2.25 0.36

5-May-08 4401.35 -11.65 -1.88

8-May-08 4425 23.65 3.81

9-May-08 4452.25 27.25 4.39

10-May-08 4448.3 -3.95 -0.64

11-May-08 4416 -32.3 -5.21

12-May-08 4391.9 -24.1 -3.88

15-May-08 4292 -99.9 -16.10


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16-May-08 4322.35 30.35 4.89

17-May-08 4414.6 92.25 14.87

18-May-08 4119.85 -294.75 -47.51

19-May-08 4005 -114.85 -18.5122-May-08 3725.9 -279.1 -44.99

23-May-08 3921.95 196.05 31.60

24-May-08 3814.55 -107.4 -17.31


Fund manager entered the futures market to minimize the portfolio risks. As per the

strategy, if you long portfolio, then short index futures. In this case, the schemes

underlying index is CNX IT. So the fund manager has to short a certain number of

contracts to cover his portfolio risks. As per assumption, fund manager has gone 50%

hedge with portfolio beta of 0.88, therefore the total asset value multiplied by beta value

to give hedging proportion. Then the difference was calculated for the day to day

movements to find out the profit or loss for the transaction.

STEP 4:

Adjustment of futures contract profit or loss in mutual funds TAV to ascertain the

adjusted NAV



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In this step, before adjusting the total profit or loss in TAV, it is necessary to ascertain the

daily difference in TAV, which has been calculated with the help of multiplying number

of units with daily NAV. Then the ascertained difference in TAV was adjusted with

profit or loss in the futures contract to find out the adjusted TAV.

*Note: P/L denotes profit or loss


Date TAV

(in millions)

Differenc

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in TAV

P/L

(in millions)

Total P/L

(in millions)

Adjusted TAV

(in millions)

2-May-08 1618.16 1618.16

3-May-08 1633.93 15.76 6.05 9.71 1627.87

4-May-08 1643.92 10.00 0.36 9.63 1637.51

5-May-08 1639.69 -4.23 -1.88 -2.35 1635.15

8-May-08 1649.30 9.61 3.81 5.80 1640.95

9-May-08 1652.38 3.08 4.39 -1.32 1639.64

10-May-08 1661.61 9.23 -0.64 9.86 1649.50

11-May-08 1648.15 -13.46 -5.21 -8.25 1641.25

12-May-08 1638.92 -9.23 -3.88 -5.34 1635.91

15-May-08 1597.02 -41.91 -16.10 -25.80 1610.11

16-May-08 1593.56 -3.46 4.89 -8.35 1601.75

17-May-08 1625.85 32.29 14.87 17.42 1619.18

18-May-08 1543.58 -82.27 -47.51 -34.76 1584.42

19-May-08 1491.29 -52.29 -18.51 -33.77 1550.65

22-May-08 1422.48 -68.82 -44.99 -23.83 1526.82

23-May-08 1468.23 45.75 31.60 14.15 1540.97

24-May-08 1445.93 -22.30 -17.31 -4.99 1535.98

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STEP 5:

Calculation of adjusted NAV and ascertainment of hedged returns


Date Adjusted

TAV

NAV Hedged daily

returns

2-May-08 1618.16 42.09

3-May-08 1627.87 42.34255 0.600

4-May-08 1637.51 42.59312 0.592

5-May-08 1635.15 42.53197 -0.144

8-May-08 1640.95 42.6828 0.355

9-May-08 1639.64 42.64855 -0.080

10-May-08 1649.50 42.90511 0.602

11-May-08 1641.25 42.69054 -0.500

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