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I have read in a book from Emanuel Derman that Goldman Sachs manufactured a derivative in the early 90's that consisted of buying cheap puts on th Nikkei index (and paid in Yen), combined them which a Yen-USD protection and resold them to clients. This construction was called "Kingdom of Denmark" puts.

To Hedge this construction they must dynamically trade Yen-USD and also the Nikkei index. Can someone explain to me why you also want to trade dynamically the Nikkei index if you want to hedge the whole construction?

I thought that if the Nikkei drops then Goldman gets paid and forwards the money to its clients. So there is no need for Goldman in protecting themselves against decreases in Nikkei index.

Any comments or thoughts are welcome!

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  • $\begingroup$ Intuitively, because of non-zero correlation between Nikkei and USDJPY Goldman did have some exposure to Nikkei, which it had to hedge. See later pages in the book where he discusses correlation, Karasinski's formula, etc. $\endgroup$ – Alex C Sep 8 at 15:11
  • $\begingroup$ @AlexC, I hope I have understood the book correctly: Let's assume that the Nikkei index and the Yen are positively correlated. If the Nikkei index had plunged the Yen would have depreciated against USD. Hence, Goldman would have wanted to be short in the Nikkei index to hedge its position. But this in turn requires another USD-Yen hedge as being short in Nikkei means receiving Yen. Is this correct? $\endgroup$ – Philipp Sep 8 at 15:58
  • $\begingroup$ That is what I think. I hope someone else here can confirm that, and put in mathematical terms... $\endgroup$ – Alex C Sep 8 at 16:27

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