Case 021Risk management and limit breachesHard
A mid cap fund with Rs 600 crore of stocks hedged by selling Rs 330 crore of large cap index futures. Mid caps fell 18% while the large cap index fell 6%. Work out the loss, the hedge gain and the net result, and explain why the hedge failed.
1The situation
Anantshayan Midcap Fund holds Rs 600 crore of mid cap stocks. Worried about a sell-off, the manager wanted to halve the fund's market exposure. Mid caps have had a beta of about 1.1 to the large cap index, so the manager sold large cap index futures worth half of Rs 600 crore times 1.1, Rs 330 crore, because the large cap future was far more liquid than any mid cap alternative.
Over the next month the mid cap stocks fell 18% and the large cap index fell 6%. The risk committee asks what went wrong.
2Your task
Work out the portfolio loss, the hedge gain and the net result, and explain why the hedge failed to protect the fund.
Quick check
If the manager had hedged the full beta exposure, Rs 660 crore of futures, what would the fund have lost?
Worked solution
Try it on paper, then open one step at a time.
30-second answerThe answer to give first
The portfolio lost Rs 108 crore, the futures gained Rs 19.8 crore, and the fund lost Rs 88.2 crore net. The hedge did its job on the market move: beta predicted a mid cap fall of 6.6%, and against that the fund would have lost only Rs 19.8 crore. But mid caps fell 18%, and the extra Rs 68.4 crore came from mid caps falling against large caps. A hedge on the wrong index is a bet on the spread between the two.
Step 1What are the three numbers?
Portfolio: Rs 600 crore times minus 18%, a loss of Rs 108 crore. Hedge: a short of Rs 330 crore gains when the index falls, 330 times 6%, Rs 19.8 crore. Net: a loss of Rs 88.2 crore, 14.7% of the fund, against the 3.3% loss the manager expected from halving the market exposure. The committee's question is where the other Rs 68.4 crore came from.
Step 2Why did the hedge fail?
Split the portfolio's fall into the part the large cap index explains and the part it does not. Beta of 1.1 on a 6% fall predicts 6.6%, Rs 39.6 crore; mid caps actually fell 18%, so Rs 68.4 crore came from mid caps doing worse than large caps, and a large cap future has no exposure to that at all. This is basis riskThe risk that the hedging instrument and the position being hedged do not move together, so the hedge gains less than the position loses.. Insuring a car with a policy that pays out on the average car in the city works only when your accident looks like the average one.
Step 3Would a bigger hedge have saved it?
Only partly. A full beta hedge of Rs 660 crore would have gained Rs 39.6 crore and still left a loss of Rs 68.4 crore, exactly the spread. Each extra rupee of large cap futures removes more of the market move, but none of the mid cap against large cap move. Hedging beyond beta would be a new bet, on large caps falling, not insurance.
| Rs crore | Expected at beta 1.1 | What happened |
|---|---|---|
| Mid cap portfolio | -39.6 | -108.0 |
| Large cap futures, short 330 | +19.8 | +19.8 |
| Net | -19.8 | -88.2 |
Step 4What should the committee change?
Three things, in order. Measure hedge effectiveness before relying on a hedge: if the large cap index explains only part of the mid cap book's variance, the rest is risk the hedge leaves behind, and it should be stated in rupees. Where a liquid mid cap index future exists, prefer it or use a mix, accepting a higher cost for a closer match. And stress the spread itself: a scenario in which mid caps fall twice as far as large caps should sit next to the beta scenario in every risk report. Say the limit: beta estimated in calm markets tends to understate how far mid caps fall in a sell-off, so the spread risk is largest exactly when the hedge is needed.
Where candidates lose it
Candidates compute the net loss and say the hedge was too small. A full hedge would still have lost Rs 68.4 crore; the problem was the instrument, not the size, and the interviewer wants the spread named.
The second miss is treating beta as fixed. A beta of 1.1 measured over calm years says little about a month in which investors dumped smaller, less liquid stocks first.
What the interviewer asks next
- If mid caps had fallen only 3% while large caps fell 6%, what would the hedge have done?
- How would you estimate the right hedge ratio, and how often would you re-estimate it?
- Why might a manager accept basis risk rather than use a less liquid mid cap future?
Asked at Schroders, Risk, New York, 2021 (Wall Street Oasis): Case study - reading about a failure to hedge risk and analyze
Company names and figures are illustrative.