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      Question

      'Hedging' in derivative markets is best described as:

      A Taking high-risk positions for large profits. Correct Answer Incorrect Answer
      B An activity that seeks to profit from price differences in two markets. Correct Answer Incorrect Answer
      C A strategy to reduce or eliminate price risk from an underlying exposure. Correct Answer Incorrect Answer
      D Speculating on future price movements. Correct Answer Incorrect Answer
      E A method to avoid paying taxes on gains. Correct Answer Incorrect Answer

      Solution

      • Hedging is a  risk management strategy . The goal is not to make a profit, but to  lock in a price or offset potential losses  from an existing or anticipated exposure in the cash (spot) market.
        • Example:  A farmer (long on crops) can sell futures contracts to lock in a sale price, hedging against a potential fall in crop prices. An importer (who will need USD in the future) can buy USD-INR futures to hedge against INR depreciation.
        • Contrast:   Speculation  (option d) involves taking on risk to profit from price movements.  Arbitrage  (option b) involves riskless profit from price discrepancies.

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