Hedging: Risk Sharing or Risk reduction

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  • #2887953
    Pravi.iyer
    Participant

    Hi,

    I have a quick question:

    Becker's B1-M1, Simulation 1 mentions that Hedging is “Risk reduction”. OTOH, Wiley CPA states that Hedging is a means of “Risk Sharing”.

    Which one of the above is correct please?

    Thank you

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    #2887992
    AusNat
    Participant

    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.

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    #2888007
    Pravi.iyer
    Participant

    thank you. But what's the correct answer to choose at the CPA exam – reduction or sharing?

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    #2888019
    AusNat
    Participant

    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.

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    #2888022
    Pravi.iyer
    Participant

    It's a Becker simulation Q

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    #2888025
    AusNat
    Participant

    A Becker simulation asked you to select whether hedging is risk reduction or risk sharing? Or did it just use a different phrase to describe something than Wiley did?

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    #2888058
    Pravi.iyer
    Participant

    Becker asked me to pick b'ween the 2.

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