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Answer: The derivative's value is highly correlated (negatively or positively) to an underlying exposure at the corporation
**Correct answer: C) The derivative's value is highly correlated (negatively or positively) to an underlying exposure at the corporation** A hedge is designed to offset the risk of an existing exposure. The strongest evidence that a derivative is a hedge is that its value moves in a way that is **closely linked to the exposure being managed**. - If the derivative gains when the exposure loses value, or vice versa, it reduces overall risk. - High correlation between the derivative and the underlying exposure is therefore a key indicator of hedging. Why the other choices are not as good: - **A)** A capped loss does not make something a hedge; it only describes the derivative's payoff characteristics. - **B)** Being zero-cost or non-directional does not by itself imply hedging. - **D)** A perfect risk-free net position is unrealistic and not required to classify something as a hedge. Therefore, the best support is **high correlation with an underlying exposure**.
Author: Manit Arora
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Question 21.8.2
Unaholding FinServices Corporation last quarter entered into a derivative contract that has since become a relatively large position. In response to a query by the Board's Risk Committee, the Chief Financial Officer (CFO) makes the argument that the derivate trade is a hedge rather than a speculation or an arbitrage. Which of the following is the best support for her argument that the trade is a hedge?
A
The potential loss on the derivative contract itself is capped (aka, limited) to a 25% loss
B
The derivative's initial value was zero, and trade is considered non-directional or range-bound
C
The derivative's value is highly correlated (negatively or positively) to an underlying exposure at the corporation
D
The net position (the derivative plus an underlying exposure) eliminates all risks; i.e., the net position is without risk
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