January 14, 2020 at 10:23 pm #2887953January 14, 2020 at 11:08 pm #2887992
They both are correct.
If I make denim and my raw materials costs will skyrocket if the price of cotton surges up, then I'm facing a risk of loss when cotton prices rise. So I buy a call option from you to purchase 25,000 lbs of cotton at $5.00 per lb. on June 1. Now, if the price of cotton goes up $1 to $6/lb between now and June 1, I'll be out $30,000 in extra raw materials cost that I need to make my fabric, BUT I'll also be able to buy $150,000 worth of cotton from you for only $125,000 when I exercise the option, so I've made $25,000 on the option and (netting the loss and the gain), my risk that cotton prices will surge in the next few months has been REDUCED to $5,000 instead of $30,000.
But there has to be a loser too. I bought that call option from someone – you. You have to sell me $150,000 of cotton for $125,000. For me to offset my potential loss with a potential gain, someone else has to enter into an opposing position and risk losing when I win. In the process of reducing my own risk from cotton prices rising, I transferred some of that risk to you when I bought the option.January 14, 2020 at 11:20 pm #2888007
thank you. But what's the correct answer to choose at the CPA exam – reduction or sharing?January 14, 2020 at 11:26 pm #2888019
Did you get a practice question on that? I can't imagine an exam asking that question and giving both of those as answer options, but if they did, I would select risk reduction. That's my purpose in entering into the hedge.January 14, 2020 at 11:27 pm #2888022January 14, 2020 at 11:29 pm #2888025January 15, 2020 at 12:04 am #2888058
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