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I was asked this in an interview and I messed it up lol. This might actually be really basic. Let's say I signed a forward contract to buy NASDAQ at 4000 one year from now. How can I hedge this cash flow?

I was thinking of buying a put at 4000 strike, so that if S_t >= 4000, I don't exercise the put and sell at market price, whereas if S_t < 4000, I exercise the put.

However, this way I have a -P cash flow at time 0. I was thinking of borrowing P at time 0, but this means I have to pay more in the future. So I am not sure how to fully hedge the position.

Thanks in advance!

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"However, this way I have a -P cash flow at time 0." - yes, and this is one of the ways to hedge a forward. There is no free lunch - you are cutting risks and paying the price of a put for it. Hedging is a process of limiting your risks, and you certainly can't guarantee a positive overall cashflow, but you do guarantee you won't loose more than P. By definition, it is hedging and your answer can't be claimed as completely wrong.

However, the asker probably wanted you to know that NASDAQ is currently at over 4000 and so you can potentially go short (you can sell future with same expiration if it is over 4000) and then buy it back at lower price and thus exercising and arbitrage opportunity. I wonder if the price of the forward has been mentioned because if it is assumed free, the question is really a bit weird. Usually there is no arbitrage and you can do the same thing at a small loss, it doesn't make any sense when talking about NASDAQ, but does make sense if you are talking about commodities when you want something delivered and don't want to overpay in the future, but also don't want to use option because you also don't want to speculate.

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  • $\begingroup$ that's exactly what i said. but the interviewer told me that I'm supposed to be able to create an arbitrage strategy from this, i.e., there is no negative cash flow and at least one positive cash flow. i ended up not getting the final round interviews.. $\endgroup$
    – Mariska
    Feb 26 '14 at 23:17
  • $\begingroup$ @Mariska Well, this is a right answer, however there certainly can be different types of hedging. Editing my answer. $\endgroup$
    – sashkello
    Feb 26 '14 at 23:22
  • $\begingroup$ @Mariska Has the price of forward contract been specified? $\endgroup$
    – sashkello
    Feb 26 '14 at 23:30
  • $\begingroup$ he assumed the forward contract is free, and also that the price of NASDAQ is below 4000, to be exact, around 3600 per today's price. $\endgroup$
    – Mariska
    Feb 26 '14 at 23:34
  • $\begingroup$ @Mariska Well, then it is an arbitrage opportunity for the one who is selling you this forward. The seller should pay you, otherwise it's free money for him/her, as I described above. $\endgroup$
    – sashkello
    Feb 26 '14 at 23:39

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