In this article we assume only long investing. For short portfolios, transactions would be in the opposite direction. The most important factors in making this decision are product availability, implementation costs, tax implications and the need for customised payoffs.

**Implementation Costs**

Futures are generally less costly to trade than the underlying costs. As a result, investors who need temporary risk reduction could benefit by hedging rather than selling out of their positions.

However, for longer-term asset allocation moves, trading the underlying might make sense. This is because futures rolling costs or swap financing spread costs could eventually outweigh the initial trading cost savings.

Futures could also be used for trading the underlying through exchange for physical (EFP) or basis trade. In these trades, investors would use the liquidity available in the futures markets to reduce the market impact of trading the underlying stocks.

**Tax Implications**

Investors could also use derivatives to defer their capital gains tax liabilities and avoid having to deal with dividend withholding. Tax liabilities and appropriate derivatives strategies of course depend on the country and tax status of the investors.

**Customised Payoffs**

Investors may not want to hedge their positions completely. In these cases, investors could use options to create customised payoffs. Two common option strategies are buying put options to hedge the downside while retaining the upside, and buying collars to cap both the upside and downside. In addition, benchmark oriented investors could use relative performance collars to lock in their outperformance versus benchmarks.

**Contract Availability**

The following table shows in a chronological order the exchange-listed index future and option contracts currently available on the Asia equity markets.

**Hedging Using Futures**

The market risk of a diversified long stock portfolio can be neutralized by shorting futures. The net result of the hedge is a cash equivalent (zero beta) portfolio plus the tracking error of the stock portfolio to the index.

The following is a procedure for constructing a hedge for a long basket using futures:

**Step 1: Calculate the Hedge Ratio**

The hedge ratio estimates how much does the stock portfolio move when the value of the index moves by one unit. Therefore, the hedge ratio of a portfolio is as follows:

**Hedge Ratio = Change in the Value of the Portfolio/Change in the Value of the Index**

For hedging the market risk, the portfolio's market beta is the hedge ratio. The investor can calculate the beta by regressing the portfolio's historic returns against the market returns, or by calculating the market value weighted average of the individual stock betas.

**Step 2: Calculate the Hedge Amount**

Once the market beta is calculated, the investor can calculate the amount needed for hedging by multiplying the hedge ratio by the market value of the portfolio.

**Hedge Amount = Hedge ratio x Market Value of Portfolio**

**Step 3: Calculate the number of futures contracts needed for hedging**

The number of contracts needed for hedging is calculated by dividing the hedge amount by the market value of the index. The market value of the index is calculated by multiplying the index level by the futures multiplier. The futures multiplier varies by contract.

**Contracts Needed for Hedging = Hedge Amount/Index Level x Futures Multiplier**

**Step 4: Sell Futures**

The investor can hedge the long stock portfolio by shorting the number of contracts calculated in Step 3.

**Hedging Using Swaps**

A common method of hedging customized baskets of stocks is through equity swaps. The key advantage of using swaps is the ability to set the underlying and terms (such as the expiration date, reset period and the dividend treatment).

Equity swaps are agreements between counterparties to exchange streams of cash flows, at least one of which is linked to the performance of an equity asset. Usually, one of the counterparties makes payments linked to a benchmark rate (i.e., LIBOR plus or minus a spread), while the other counterparty makes payments linked to an equity index or a customized basket of stocks. In practice, only one net payment is made per specified period.

Investors should note that swaps are essentially financing instruments where the actual market transactions usually take place on the part of the counterparty as a position hedge. Because swaps are usually marked at execution prices, market impact and bid-offer spread are still incurred.

**Hedging Using Index Put Options**

Investors can hedge the downside of their portfolios by buying index puts. There is however, a major difference between index options and futures as far as hedging is concerned. Hedging with index futures eliminates downside risk but also removes upside potential. On the other hand, index options provide Insurance. That is, an equity portfolio is protected against a fall in stock prices but it retains its upside intact (less the cost of the puts).

The following is a procedure for hedging the market risk using index put options:

**Step 1: Calculate the Hedge Ratio**

For hedging the market risk, the hedge ratio is the market beta.

**Step 2: Calculate the needed Hedge Amount**

**Hedge Amount = Hedge Ratio x Market Value of Portfolio**

The investor can calculate the needed hedge amount by multiplying the hedge ratio by the total market value of the portfolio.

**Step 3: Calculate the number of option contracts needed**

The number of contracts needed for hedging is calculated by dividing the amount to hedge by the market value of the index option.

**Contracts Needed for Hedging = áHedge Amount/Index Level x Futures Multiplier**

**Step 4: Buy Index puts**

Buy the number of index puts indicated in Step 3. The investors generally buy at-the-money or out-of-the- money puts. The at-the-money would protect the downside from the existing index level, while the out-of-the-money would provide protection that kicks in below the current level.

The previously outlined hedge is called a fixed hedge because it involves the purchase of put options with nominal value equivalent to the value of the equity portfolio.

Delta hedging takes into account the delta of the options. Delta hedging ensures that changes in the value of the portfolio are offset by gains in the put option position.

**Hedging Using Collars**

The collar strategy limits the portfolio risk exposure to a predetermined range. As a result, investors who have collars on their portfolios know their best and worst payoff scenarios. Collars are useful for locking in profits and for reducing risk of a significant price decline. Collars are particularly attractive to investors looking to lock in profits prior to the end of the valuation period. Also, pension fund managers tend to use them to lock in the equity fund surplus resulting from strong rallies in the market.

A collar can be created by buying out-of-the-money puts and selling out-of-the-money calls on top of the existing long stock portfolio. The "Zero-Premium" collar is a popular version of this strategy. Because the listed options markets offer limited strike prices and expiration the usual way to create "zero-premium" collars is through the OTC market.

To create a collar investors need to follow the next steps:

**Step 1: Calculate the hedge ratio**

For hedging the market risk, the hedge ratio is the market beta.

**Step 2: Calculate the amount needed for hedging**

Once the beta is calculated the needed hedge amount is found by multiplying the hedge ratio by the total market value of the portfolio.

**Hedge Amount = Hedge Ratio x Market Value of Portfolio**

**Step 3: Calculate the number of option contracts to buy and sell**

**Contracts Needed for Hedging = Hedge Amount/Index Level x Options Multiplier**

**Step 4: Buy index puts and sell index calls**

Using the number of contracts indicated in Step 3, create collars by buying puts and selling calls (1:1). For a zero-premium collar, find the put and call contracts with matched prices. The cap on the upside takes effect at the call option's strike price and the floor on the downside takes effect at the put option's strike price.

**Risks of Hedging**

While hedging reduces the price risk of portfolios, it introduces a new set of risks. Some of the risks associated with hedging are:

**Tracking-Error Risk**

When the constituents of the portfolio and the hedge instrument's underlying are different, investors would be subject to tracking error risk. Tracking error is measured as the standard deviation of the return differential between the portfolio and the index.

**Basis Risk**

Futures can deviate from fair value. Normally, the pricing deviation is within a band. When futures trade out of this band, arbitrageurs would bring the underlying index and futures in line.

**Convergence Risk**

Stock index futures need to converge to the value of the index on expiration. If this condition is not met, then arbitrageurs have less incentive to take on positions, which results in wider futures mispricing and less liquidity.

**Dividend Risk**

To arrive at fair values for options and futures, future dividends need to be estimated. While dividend patterns are stable in certain stocks, in other stocks, dividend payout could be erratic. This could create sudden shifts in the fair value of futures and calendar spreads.

**Liquidity Risk**

Liquidity risk applies to both listed and over-the-counter instruments. Listed instruments are susceptible to market impact. OTC instruments have liquidity risk that is slightly different. First is the market impact incurred at the outset and unwind of the contracts (since OTC instruments are often based on hedge execution). Second, is the potential need for an unexpected unwind.

**Counterparty Risk**

Counterparty risk is specific to over-the-counter instruments. Investors need to ascertain that their counterparties are not likely to default.