CatIns Corp.(a fictitious name)sells homeowners' insurance contracts to homes along the shores of the Gulf of Mexico.The contract provides protection against hurricanes and has the following features:
•Annual premium $20,000.
•Fixed deductible $10,000.
•Maximum coverage amount $400,000 (which is less than the value of each home).
•The contract pays for losses from one hurricane in a given year.
Assume that if a hurricane hits,it does the same dollar damage to all homes covered by the insurance policy.
-An insurance company has insured oil fields in the Mideast (which includes Iran,Iraq,Kuwait,Saudi Arabia,and United Arab Emirates).Next,it purchases reinsurance to manage its "tail risk." The reinsurance company decides to hedge some of its risks by trading derivatives.In this context,which derivative trade is unlikely to be effective?

Question

Quizplus · Accepted Answer

Selling oil futures would be an ineffective hedge for the reinsurance company because it would leave them exposed to potential losses if oil prices increase. Buying oil futures or call options and entering into a commodity swap where they receive a fixed rate payment in exchange for the average oil price would all provide protection against potential increases in oil prices. Selling put options on oil futures would provide protection against decreases in oil prices.