Common mistakes made when hedging include: the possibility of having a natural hedge; liquidity risk; and base risk.Which of the following does NOT represent one of these three possible risks?
A) Future contracts are negotiated as agreements between parties that are not anonymous. Therefore, there is a possibility that one of the parties may default before the contract is finalized.
B) The hedge may not be necessary if the firm can effectively pass future cost increases on to their customers through higher prices .
C) In the event that price changes during the life of the contract require an increased contribution to the margin account, this may be an unanticipated cost for the firm and, if not addressed, could result in a default in the position taken in the contract.
D) Future contracts require the matching of the quantity and timing of future deliveries. If both parties cannot provide this matching, one party will be unable to completely hedge their future position.

Question

Quizplus · Accepted Answer

A) The risk identified in this example is a risk associated with a forward contract, not a futures contract. This default risk is eliminated under a futures contract since parties are anonymous and there is the requirement of a margin account deposit which is adjusted daily based on commodity price movements over the life of the contract.

Common Mistakes Made When Hedging Include: the Possibility of Having