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Answer: Exchange-based derivatives can minimize counterparty credit risk through the use of netting and margin requirements.
**D is correct.** An advantage of using exchange-based derivatives is that they can minimize counterparty credit exposure through margin requirements and netting arrangements. **A is incorrect.** Exchange-based derivatives are designed to attract trading liquidity. Most can be traded fairly easily at a relatively low transaction cost, but these derivatives do not have zero transaction costs. **B is incorrect.** A downside of using exchange-traded derivatives is that it is difficult for the risk manager to find a perfect fit for the position the manager wants to hedge. For example, a commodity risk manager may find the available futures contract does not cover the exact risk type, has a timing mismatch, or captures the price in the wrong location. **C is incorrect.** The potential mismatches between exchange-traded instruments and the underlying position described above create basis risk. A privately traded bilateral OTC transaction would be more effective in minimizing basis risk.
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A risk manager at a trading firm is assessing the strategies proposed by an analyst to hedge several positions in the firm's trading portfolio. The risk manager notes that the analyst recommends the use of exchange-based derivatives to hedge most of the positions. Which of the following is an advantage of using exchange-based derivatives for hedging?
A
Exchange-based derivatives can be traded without incurring transaction costs.
B
Exchange-based derivatives offer flexibility in terms of customizing the hedging instrument to match the position that the firm wants to hedge.
C
Exchange-based derivatives are typically more effective in reducing basis risk in a hedging transaction compared to bilateral OTC derivatives.
D
Exchange-based derivatives can minimize counterparty credit risk through the use of netting and margin requirements.
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