Question

1. Note whether the following are ways to avoid losses through hedging or insuring:
   1. Lock in a $979.00 fare home for the holidays. (Hedging/Insuring)
   2. Purchase a put option on a stock you do own. (Hedging/Insuring)
   3. Agree to purchase a house in one year for a fixed price of $200,000. (Hedging/Insuring)
   4. Lease a car with an option to purchase it in three years. (Hedging/Insuring)

Answer 1

Solution.>

Part a> This is a way of Insuring. When you insure, you pay a price (the premium) to eliminate the risk of loss and retain the potential for gain. Here we are locking a fare home for the holidays, which is a clear case of Insuring.

Part b> This is a way of hedging. When you hedge, you eliminate the risk of loss by giving up the potential for gain. We bought the put options and removed our risk of decline in share prices. In this case, we have not retained our gain potential (i.e. there is no 100 percent assurance of profit). We will only benefit if the share prices increase considering the time value of capital and the intrinsic value of options by a huge amount.

Part c> This is a way of hedging. When you hedge, you eliminate the risk of loss by giving up the potential for gain. In the above example, we removed our loss of price increase when setting the property prices beforehand. And if the price falls by an immense amount, we still have to buy the property at a fixed amount. There is therefore no future advantage.

Part d> It is a clear way of insuring to prevent damages. Nothing is determined in this case as to what price it will be purchased at. Hence this will not be considered as a case of hedging.

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