Hi In the ques a liab of a fund that promises to pay a return equal to the increase in capital value of an equity index over a 5 yr period subject to a min of 0 needs to be hedged. The answer states that one of the options is a portfolio of equities that tracks the index/forward contract and an OTC put option based on the index value. Pls explain how this combination (equities+OTC put)can hedge the liability.I am a bit confused in this.
Hi Nimisha Imagine that the equity index has a positive return over the five year period - if the fund holds a portfolio of equities that tracks the index this will give the fund the same return, enabling it to meet its obligations at the end of the five year period. Eg it could sell the equity portfolio and pay the proceeds to investors The put option gives the fund the right but not the obligation to sell the portfolio of equities / index for a specified price. So if the portfolio of equities falls in value over the five year period, the fund can exercise the put option and effectively receive the original value, again enabling it to meet its obligations to investors ie to pay out at least the original value of their investment.
