A firm owns an asset A and it wants to hedge against changes in the value of A by making an offsetting sale of asset B. The firm minimizes risk by
A)selling the same number of units of B as assets of A.
B)selling hedge ratio (delta)number of units of B.
C)selling the reciprocal of hedge ratio number of units of B.
D)buying the same number of units of B as assets of A.

Question

Quizplus · Accepted Answer

The optimal hedging strategy involves selling a proportion of asset B that corresponds to the delta (hedge ratio) of asset A, rather than simply selling the same number of units of B as assets of A. This is because the delta represents the correlation between the two assets and will ensure that the hedge is most effective in reducing risk. Choosing options A, C, or D would result in either under- or over-hedging the position, leaving the firm exposed to some degree of price risk.

A Firm Owns an Asset a and It Wants to Hedge