Cutting Beta with SXF Futures
You manage a $20 million Canadian equity portfolio with a beta of 1.15 against the S&P/TSX 60 Index. In June you expect an 8-10% market correction over the next four months, but the client is taxable, holds large unrealized gains, and has instructed you not to sell securities. You propose cutting portfolio beta to 0.70 using SXF futures (multiplier $200 per index point), currently quoted at 1,340.00 for the September contract. The index dividend yield is 2.8% and 90-day financing is 4.5%. The account holds $1.2 million of marginable cash and securities. The client's Investment Policy Statement permits derivatives for hedging only, never for speculation, and requires the futures position to be reported monthly. The portfolio's holdings will not change during the hedge period.
1. How many contracts, and in which direction? Show the calculation and explain the effect of rounding.
Read the worked answer
Sell futures. The formula is:
Contracts = (target beta - portfolio beta) x portfolio value / (futures price x multiplier) = (0.70 - 1.15) x $20,000,000 / (1,340.00 x $200) = -0.45 x $20,000,000 / $268,000 = -$9,000,000 / $268,000 = -33.58
Because beta must fall, the position is short: sell 34 SXF contracts. Each contract controls $268,000, so 34 contracts represent $9,112,000 of notional exposure against the $9,000,000 needed to remove 0.45 of beta. The hedge ratio is 9,112,000/20,000,000 = 0.456, so the resulting beta is about 1.15 - 0.456 = 0.694 - slightly below target and immaterial.
Rounding to 34 rather than 33.58 over-hedges by 0.42 of a contract, about $112,560 of notional or 0.006 of beta. The larger risks are that beta is estimated rather than observed and can drift over four months, so the ratio should be rechecked monthly and adjusted.
The position fits the IPS because it reduces risk rather than adding it, but it must be reported monthly and the account must hold enough marginable assets for variation margin. Initial margin is a few percent of notional, but a rising market triggers daily cash calls, which the $1.2 million of collateral comfortably covers.
2. At expiry the index is at 1,232.80 (down 8.0%) and the portfolio has fallen 9.2%. Compute the hedged result and evaluate how well the hedge worked.
Read the worked answer
Futures gain: (1,340.00 - 1,232.80) x $200 x 34 = 107.20 x $200 x 34 = $728,960.
Portfolio loss: 9.2% x $20,000,000 = $1,840,000.
Net result: -$1,840,000 + $728,960 = -$1,111,040, or -5.56% of the portfolio.
That matches the target almost exactly. With beta cut to 0.70, the expected loss was 0.70 x 8.0% = 5.6%; the portfolio delivered 5.56%. The hedge worked. The residual difference comes from the 34 versus 33.58 rounding and from the fact that the realized portfolio return of 9.2% happened to equal 1.15 x 8.0%.
Tracking error sources to monitor:
- Beta instability. A portfolio whose holdings change will not track 1.15; this one is held static, which helps.
- Index mismatch. The futures track 60 large caps; the portfolio does not.
- Dividends and carry. The portfolio keeps receiving dividends, but the futures price already embeds the index dividend yield and financing, so a hedged portfolio earns roughly the risk-free rate rather than the equity return; any gap between the portfolio's dividend yield and 2.8% shows up as tracking error.
- Rollover. If the view extends past September, rolling to December costs a spread.
- Margin timing. Gains arrive as daily cash, not at the end, which must be managed.
3. Compare the futures hedge with buying index put options instead.
Read the worked answer
Four-month at-the-money puts on the index would cost roughly 2-3% of notional in a normal volatility environment - perhaps $180,000 to $270,000 to protect the $9 million of notional being hedged. That premium is a certain cost, whereas the futures hedge costs nothing up front but gives up upside.
Key differences:
- Symmetry. Futures lock in the beta reduction. If the market instead rises 8%, the portfolio gains about 9.2% but the short futures lose about $720,000, netting roughly 5.6%. Long puts let the portfolio keep the full gain less the premium.
- Margin. Futures require daily variation margin and cash management; long options require no margin and no cash calls, which matters for a taxable client who does not want to sell assets.
- Strike and delta. A 5% out-of-the-money put protects much less than it appears, and delta falls as the market drops, so protection is incomplete without active adjustment.
- Liquidity. Index options near the money in standard months are reasonably liquid; further out or longer-dated strikes are not.
Both are hedging under the IPS. If the manager expects a correction but is uncertain about timing, puts cap the cost of being wrong. If conviction is high and the horizon defined, futures are cheaper and more precise.