Financial institutions use derivatives instruments to hedge their asset–liability risk exposures. The financial institutions` goal is...

Financial institutions use derivatives instruments to hedge their asset–liability risk exposures. The financial institutions` goal is to reduce the value of their net worth that is at risk due to adverse events.

What are the reasons why a financial institution may choose to hedge its portfolio selectively?
Substantiate your response with examples.

Expert Solution

Financial institutions reduce the risk of their investments by hedging. The term hedging refers to the use of financial instruments in such a way that the fluctuations in the market will not influence the value of the investment. The portfolio of a financial institution is the combination of several assets and liabilities. A financial institution may hedge their portfolio selectively by choosing only those investments that have high risk. The price movements of the assets that are influenced by the market should be hedged so that the financial institution does not face loss. The main purpose of hedging selectively is to offset the risk of loss.

Example: A financial institution may reduce their risk by investing in forward contracts and future contracts.

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Financial institutions use derivatives instruments to hedge their asset–liability risk exposures. The financial institutions` goal is...

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