Question

1. Using the table below show and explain whether the two assets A and B are ideal for Hedging    

State of the world	Probability	Return A	Return B
Expansion	25%	32%	5%
Normal	50%	14%	15%
Recession	25%	4%	25%

Answer 1

Expected Return for A is (0.25*32)+(0.50*14)+(0.25*4)= 16%

Expected return for B is (0.25*5)+(0.50*15)+(0.25*25) = 15%

Let us assume we have a total of $100 to invest and we invest it 50:50 in A and B.

Let us say the world is in expansion, then having investment only in security B would lead to lower returns. But if we also invest in A, we would be better off. Our returns would be (50*.32)+(50*.05) = 18.5%

Similarly, if the world is normal, then we have 14.5% return

When world is in recession, here investment in B saves us and gives us good returns. Lur returns would be (50*.04)+(50*.25)=14.5%

Thus, these assets are a good pair as when one generates low return, the other generates good returns. Thua, they are ideal for hedging.