Question

Given: Portfolio - $1 billion

Given: Forward Contract - $1 billion, today’s index (spot) price is 100, forward contract price 1 year from now is 95.

Given: Assume that your portfolio and the forward contracts have a Beta of 2 with the market.

- How well does the hedge work now compared to if the Beta was 0?

- Does the hedge perform different when the market is going up versus going down?

Answer 1

Beta of 2 indicates that the portfolio is two times volatile when compared to the broader market.

Beta is 0 implies that the portfolio gives risk-free returns and is independent of the market volatility. In such cases, the hedge has no value as there is no inherent volatility from which you would want to hedge the portfolio.

Hedge works in a similar fashion in both cases where the market is going up or going down. Because when you are hedging with a forward contract, you fix the future price of the asset after a particular period of time. If the market goes down or moves up, it doesn't make a difference as the price is fixed.