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    Hedge Against Systematic Risk

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    I have an expected cash flow of $1,000 in one year. 1.2 is the beta for the common stock and 1.2 is also the beta of my cash flow. The risk-free rate is 4% and the market index has a 5% risk premium.

    How could I hedge against the systematic risk? What kind of strategy is needed? What is shorted, what is longed, and how much of each, etc?

    What is the maximum hedging cost after which I should abandon the idea of hedging the systematic risk?

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    Solution Preview

    E(St) = $1000
    PV of cash flows = 1000/[1+4% + 1.2*5%] = 1000/[1+0.04 + 0.06] = 1000/1.1 = 909.1
    F(0) = $909.1

    You can eliminate systematic risk by ...

    Solution Summary

    This solution provides discusses hedging and provides steps necessary to answer each of the given questions.