Pass Certification Examination for Mutual Fund - Specialized Investment Fund Distributors Difficulty: Intermediate 2 Questions   5 min read
📌 Chapter 17.1 — Futures contracts for hedging, speculation and arbitrage

Consider a HNI client who approaches you, worried about a 10% correction in their equity portfolio. They insist on hedging their ₹50 lakh exposure using Nifty index futures, but they refuse to allocate the full margin required to hedge the entire portfolio value due to liquidity constraints. This is a classic scenario where a client seeks partial hedging, hoping to protect a portion of their gains while maintaining some upside exposure.

As a distributor, you must explain that hedging is rarely a one-size-fits-all binary switch; it is a delicate balance between cost and protection.

Partial hedging occurs when the hedge ratio is set below the ideal levels required for full immunity against systematic risk. When an investor shorts fewer futures contracts than the delta-equivalent of their cash portfolio, they remain exposed to basis risk and market volatility.

In the Indian market, where indices like the Nifty 50 or Bank Nifty are used as proxies for portfolio movement, the divergence between the actual stocks in the client’s basket and the index composition creates an inherent mismatch. This means even a hedge that looks mathematically perfect on paper may fail to offset losses when market correlations break down during a sharp downturn.

From a professional advisory standpoint, the danger lies in the client’s expectation. If you recommend a strategy that provides only partial protection, the client might be lulled into a false sense of security. If the market drops, they may see their losses mitigated but not eliminated, potentially leading to dissatisfaction or accusations of mis-selling if the risks were not disclosed properly.

For SIF strategies that utilize index futures for hedging, fund managers often aim for near-perfect hedging, but retail investors attempting this on their own portfolios rarely achieve such precision due to the lack of dynamic rebalancing.

Always ensure that your suitability assessment accounts for the investor’s ability to withstand the unhedged portion of their portfolio. A client who believes they are fully ‘insured’ against market drops is likely to react poorly to any portfolio decline. By clarifying the limits of partial hedging, you manage their expectations and reinforce your role as a diligent advisor who prioritizes transparent risk communication over simplistic, headline-grabbing solutions.

Nuance

⚠️ Nuance
Candidates often assume that any futures hedge provides a linear safety net, ignoring the reality of ‘basis risk’ and ‘correlation drift.’ In practice, the index being used for the hedge may not move in perfect tandem with the specific stocks held in a portfolio. A common misconception is that partial hedging is merely a ‘scaled-down’ version of full hedging, failing to account for the fact that non-linear market shocks often hit non-indexed stocks harder than the index itself.

Check Your Understanding

Practice Question 1

An investor with a portfolio beta of 1.2 holds a ₹1 crore portfolio and decides to hedge only 50% of the systematic risk using Nifty futures. Which of the following is the most likely consequence of this partial hedge?

Practice Question 2

When evaluating a SIF that employs a partial hedging strategy using index futures, what should a distributor highlight to a client to ensure proper disclosure and suitability?

This is a companion read for Section 17.1 — Futures contracts for hedging, speculation and arbitrage from Pass Certification Examination for Mutual Fund - Specialized Investment Fund Distributors by Akhilesh Gururani, available on Amazon Kindle.

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