Hedging with Nifty Futures
Hedging an equity portfolio with Nifty futures involved selling a calculated number of Nifty futures contracts proportional to the portfolio's beta-adjusted value, with the objective of offsetting potential losses in the equity portfolio during market declines without liquidating the underlying holdings.
Portfolio beta represented the expected percentage change in a portfolio's value for every 1% move in the benchmark Nifty 50 index. A portfolio with a beta of 1.2 was expected to move 12% for every 10% Nifty move. To hedge such a portfolio against a market decline, the trader needed to sell enough Nifty futures to offset the expected portfolio loss. The hedge ratio formula combined portfolio value, Nifty futures contract value, and portfolio beta.
For a portfolio valued at Rs 1 crore with a beta of 1.2 and Nifty at 22,000 with a lot size of 50, the Nifty futures contract value equalled Rs 11 lakh. The required number of short futures contracts would be approximately (1,00,00,000 × 1.2) / 11,00,000, or roughly 11 contracts. This meant the trader would short 11 Nifty futures lots to achieve a near-complete market hedge.
In practice, portfolio beta was estimated over a recent historical window and recalculated periodically. Individual stock betas varied over time, and portfolio composition changes required hedge ratio updates. Imprecise beta estimation introduced basis risk — the possibility that the portfolio did not move exactly in line with the hedged Nifty position, resulting in under- or over-hedging.
Mutual funds and large institutional investors used index futures for temporary hedging during high-risk periods, such as before major macro events like the Union Budget or general elections. Rather than selling equity holdings — which would trigger transaction costs and potential capital gains taxes — institutions used Nifty futures to reduce net exposure while retaining their long-term equity positions.
Hedging costs included the futures basis (the premium or discount of futures to spot), daily mark-to-market settlement flows, and the opportunity cost of margin blocked. In a rising market, a hedge produced ongoing mark-to-market losses on the short futures position even as the equity portfolio gained, creating a psychological and practical discipline challenge for sustaining hedges over extended periods.