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Question

Which of the following can be used for risk shifting?  

A Shares Correct Answer Incorrect Answer
B Debentures Correct Answer Incorrect Answer
C Derivatives Correct Answer Incorrect Answer
D Insurance policy Correct Answer Incorrect Answer
E All of the above Correct Answer Incorrect Answer

Solution

Risk shifting involves changing (“shifting”) the distribution of risky outcomes. It is different from Risk transfer which is passing on (“transferring”) risk to a third party. Both are risk mitigation strategies. Risk shifting is possible through the use of derivatives. For example, financial firms that do not want to bear currency risk on some foreign currency-denominated debt securities can use forward contracts or swaps to reduce or eliminate that risk. This is the way of changing the distribution of possible outcomes which is done through derivatives. Note - In some cases, risk transfer and risk shifting is also used interchangeably.

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