Question

Joseph is a junior risk analyst who has recently prepared a report on the advantages and disadvantages of hedging risk exposures. An excerpt from her report contains four statements. Which of Joseph’s statements is correct? [2]
(a) Purchasing an insurance policy is an example of hedging.

(b) In practice, hedging with derivatives is not likely to be a zero-sum game.

(c) The existence of significant costs of financial distress and bankruptcy is considered within the assumption of perfect capital markets.

(d) Hedging with derivatives is advantageous in the sense that there is often the ability to avoid numerous disclosure requirements compared with other financial instruments.

Answer 1

Ans. Option(d) is the correct answer since the hedge is a word which is used to transfer risk by investment, we eliminate option(a) because purchasing an insurance policy is a way to reduce risk by paying to insurance companies who bear those risk however hedging is a way to transfer risk by investing in financial securities.

Option(b) is not correct because hedging with derivatives is likely to be zero-sum game since zero-sum game means the gain of one person will be equivalent to the loss of another person, and the derivative is also used to transfer of one person loss to another person.

Option(c) is also not correct because this is not generally true that the existence of financial distress and bankruptcy is considered in the assumption of perfect capital markets.

Therefore the option(d) is correct.