Dhoran Capital is long Rs 100 crore of stocks with a beta of 1.0 and short Rs 80 crore of an index basket. In a sell-off the index falls 10%, but the longs fall 14%. What does the book lose, what did the beta model predict, and what failed?

The book lost Rs 6 crore against a predicted Rs 2 crore, 6% of capital and through the 5% limit. The longs lost Rs 14 crore and the index short made Rs 8 crore. The hedge did its job on the market move; what failed was the assumption that the longs behave like the index. They fell 4 points more, a Rs 4 crore residual from factor and crowding risk that no index short can remove.

Net the positions in beta terms. Rs 100 crore of beta-one longs against Rs 80 crore of index short leaves Rs 20 crore of net market exposure, so a 10% fall should cost Rs 2 crore, 2% of capital. In fact the longs fell 14%, a Rs 14 crore loss, and the short made Rs 8 crore, leaving a Rs 6 crore loss. That is three times the prediction and enough to cut the pod's capital in half under the platform's rule.

Split the loss into the part the hedge was built for and the part it was not. The market move cost the longs Rs 10 crore and the short recovered Rs 8 crore; the extra Rs 4 crore is the longs falling 4 points more than a beta of one implies. An umbrella keeps off the rain but not a splash from a passing bus: the index short covered the market, and the residual came from somewhere else. The longs' realised beta in the sell-off was 14 over 10, about 1.4, not 1.0.

Three things, each common in a sell-off. First, beta was measured over two calm years, and betas of mid cap growth names rise when markets fall. Second, the longs shared a factor exposureA common driver such as size, growth, momentum or value that moves a group of stocks together, separately from the overall market.: mid cap growth, which the broad index barely holds. Third, crowding: if other funds own the same names, they all sell at once when they cut risk. A beta hedge removes market risk only; factor and crowding risk stay in the book unless they are hedged with baskets that share them. The fix is to hedge with a custom basket or factor-matched shorts, stress test the book with sell-off betas rather than average ones, and size gross exposure to the worst plausible residual, not the average.