Hedging a Forward Purchase with a Put Option
Summary
The document considers how to hedge an obligation to buy an asset under a forward contract at a future date. Buying a put with a strike equal to the forward purchase price establishes a floor on the value obtainable by selling the asset, but it requires paying an option premium upfront. Financing that premium creates a future repayment obligation, so the hedge has a cost rather than guaranteeing a positive overall cash flow.
The answer also raises the importance of the forward’s market price and contract terms. If the agreed purchase price differs from the prevailing forward price, offsetting positions may create an arbitrage opportunity; when prices are aligned under no-arbitrage conditions, a hedge can still involve a cost. The discussion notes that this setup may be more relevant when a buyer needs physical delivery, such as in commodities, than when the aim is simply to speculate. It offers a conceptual explanation, not a full valuation or cash-flow derivation.
Key ideas
- A put struck at the forward purchase price can limit losses from a falling underlying asset.
- The put premium is an upfront cost and must be included when assessing the hedge’s total cash flows.
- Borrowing to pay the premium shifts the cost into the future rather than eliminating it.
- The forward price and contract terms determine whether offsetting trades may offer arbitrage.
- A hedge limits selected risks but does not guarantee a profit.
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Full text
# How to hedge a forward contract # How to hedge a forward contract 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! ## Answer by sashkello (score 1, accepted) https://quant.stackexchange.com/a/10393 "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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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.