Forward contract hedge and market-maker

Question

Referring to McDonald's Derivatives Markets book, a market-maker or arbitrageur must be able to offset the risk of a forward contract. It is possible to do this by creating a synthetic forward contract to offset a position in the actual forward contract.

For example, a customer buys a forward contract on a stock from a market-maker. The market-maker is left with short position in a forward contract and in order to hedge the short position, the market-maker can create a synthetic long position by borrowing and buying a tailed position in the stock (so-called cash and carry strategy). So in theory, the market-maker successfully created the hedged position and is not affected by price risk.

But, what I do not get is, why doesn't the market-maker just buy an offsetting long forward position from some another customer and create the offsetting long position? What I am missing here, isn't it possible (in theory or in practice)?

Answer 1

Liquidity

Forward contracts are not heavily traded, so there is unlikely to be another forward contract available that can exactly offset the one sold (for a profitable price).

The easier (and cheaper) option is to borrow money, buy the stock and pay the interest.

If one could buy a forward contract that was cheaper than the cost of borrowing money, buying the stock and paying the interest, then one could buy that forward contract, sell the stock, collect the interest and make a profit...

Answer 2

The market-maker can and does offset the position they enter into (short forward in this example) with its exact opposite, if available to them. Mind you, barring any collateral management, this would still leave the market-maker with some counter party risk.

In practice, market-makers would offset the underlying price change risk with variety of instruments including forwards, futures, highly correlated other securities, credit default swaps, options, etc. It is the job of traders and risk managers to hedge effectively and to understand where residual risks remain.

Market makers even try to "create" market for the type of exposure they need, if hedging is difficult or expensive. For example, market-makers face demand from insurers and institutional investors for options, which pay if markets open significantly lower from a previous close. Such exposure is very difficult to hedge, so that market-makers try to sell warrants, that pay high coupon, but the principal takes a hit, when the market opens with a gap in order to offset the risk from the options they have sold.