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Definition of Beta Hedge

Several of the exams require test takers to master the concept of a beta hedge. A beta hedge takes into consideration the portfolio’s volatility relative to the market as a whole. Another way to look at a beta hedge is, to say that the hedge must account for the risk adjusted value of a portfolio.

Applying "Beta Hedge" to Securities Exams:

Here we will exam how to calculate a beta hedge based on a portfolio with a beta of greater than one using S & P 500 futures contracts. Aggressive managers may have to adjust the value at risk for their portfolios to hedge effectively based on the volatility or beta of their portfolios. A stock’s or portfolio’s beta is its projected rate of change relative to the market as a whole. If the market was up 10% for the year, a stock or portfolio with a beta of 1.5 could reasonably be expected to be up 15%. A stock or portfolio with a beta greater than one has a higher level of volatility than the market as a whole and is considered to be more risky than the overall market. A stock or portfolio with a beta of less than one is less volatile than prices in the overall market and is considered to be less risky. If the $160,000,000 portfolio above had a beta of 1.5, the manager would have to determine the beta?adjusted value at risk by multiplying the $160,000,000 value of the portfolio by the portfolio’s beta of 1.5. The beta?adjusted value at risk would now be $240,000,000. Now the manager must divide the beta?adjusted value of the portfolio to be hedged by the value of the S&P contract. In this case:

$240,000,000 ÷$400,000 = 600 contracts

Portfolio managers who oversee portfolios whose holdings may be included in other indexes may choose to hedge using futures on other indexes such as:

  • Nasdaq 100
  • Dow Jones Industrial Average
  • NYSE Composite
  • Russell 2,000
  • Value Line
  • Nikkei 225
  • Be sure you have mastered financial hedging prior to taking the series 3 exam with our Greenlight Guarantee

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