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.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

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.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.

Quizplus · Accepted Answer

The best choice would be to sell a hedge ratio (delta) number of units of asset B. Hedge ratio is the ratio of the value of the asset being hedged (A) to the value of the asset used for hedging (B). This ensures that the firm retains some exposure to movements in the underlying asset (A) while offsetting a significant portion of the risk. Selling the same number of units of B as assets of A (Option A) or buying the same number of units of B as assets of A (Option D) will not manage the risk effectively. Selling the reciprocal of the hedge ratio (Option C) will completely eliminate the exposure to the underlying asset and might not provide adequate risk management.

A Firm Owns an Asset a and It Wants to Hedge