Experts have always advised investors to reduce risk in their investment portfolio by diversifying. However, even the most diversified portfolio fluctuates according to market movement. In this article, we take a closer look at managing equity market risks with the use of derivatives. By the end of this article, you as an investor will be able to identify:
- the two basic risks inherent in an investment portfolio; and
- how futures, as a form of derivatives, is used to manage market risks and turn one’s investment profile from equity to risk-free bond.
What is Equity Market Risk?
In the equity market, risk basically means the unpredictability of the expected return and how it affects the investment portfolio. There are two basic risks inherent in an investment portfolio: unsystematic risk or firm-specific risk (diversifiable) and systematic risk or market risk (non-diversifiable). When a portfolio is diversified, it basically means the firm-specific or asset-specific risk arising due to specific characteristics of the firm is removed. But of course, market risk, which is inherent in the portfolio, can never be fully eliminated because it is caused by the overall stock market and economic situation.
Risk: Good or Bad?
Many investors wrongly perceive risk as bad for their portfolios. Yet at the same time, it is widely understood by investors that risk and return go hand in hand. In order to earn higher returns, we must assume higher risks. So, if we eliminate all risk, we will only earn risk-free returns, which is equivalent to risk-free rates. What all investors ultimately want is to preserve or enhance upside risk while minimising or eliminating downside risk.
Many investors also think that derivatives are financial instruments that are highly risky. They do not relish the idea of using derivatives to manage portfolio market risk. In actual fact, the development of financial derivatives instruments provides new ways of managing risk for investors!
Taking Advantage of Futures to Hedge Market Risk
Futures are standard contracts being traded on the exchange. They are one of the most common derivatives used to manage equity market risk. Since most futures are based on broad indices, they can be used to manage the risk related to the indices that the futures are based on.
For example, if an investor is optimistic that the overall economy is heading towards recovery, but his current stock holdings are not big or diverse enough to resemble
market exposure[1], he can consider buying futures contracts that are based on the broad market index. By doing this, when the market goes up, he will gain higher profits than his original portfolio. However, in the event that the market heads downwards, his losses will also be more than what he would lose in his original portfolio.
Now, assume an investor is currently holding a well-diversified portfolio, and based on his own observation, thinks the market may be heading downward. Instead of selling his current stock holdings, he can choose to hedge his portfolio by selling futures contracts. The amount of contracts to sell will depend on how much market risk the investor would like to
hedge[2]. When the market actually drops, the investor will close his positions in the futures contracts and the profits earned can then be used to offset the drop in the value of his investment portfolio. However, if the market goes up, the losses in the futures contracts will also offset the increase in the value of this portfolio. By using futures to hedge his portfolio risk, he gets downside protection but at the same time foregoes upside potential.
In extreme cases, if the investor is very pessimistic about market conditions, he may choose to fully hedge his portfolio by selling the amount of futures contracts that is equivalent to the value of his investment portfolio. Effectively, the investor would be turning his investment profile from equity into a
risk-free bond[3]:
Conclusion
Futures enable investors to change their risk and return profiles without changing their investment holdings. This is very important as oftentimes, ups and downs in the market are only temporary. If investors were to change their investment holdings to get broader market exposure, they would need more capital and incur a lot more transaction costs compared to using futures. Additionally, to change the stock holdings would mean investors need to do in-depth research before deciding what to sell or buy.
Ultimately, using futures to manage equity market risk gives the flexibility of altering your equity market risk profile without changing your stock holdings, making it a very viable market risk management solution for any investor.
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[1] The exposure of a portfolio to particular securities/markets/sectors must be considered when determining asset allocation since it can greatly increase returns or, if properly done, minimise losses. For example, a portfolio with both stocks and bonds holdings will typically have less risk than a portfolio with exposure only to stocks.
[2] To make an investment to reduce the risk of adverse price movements in an asset. Normally, a hedge consists of taking an offsetting position in a related security, such as a futures contract.
