Financial Accounting and Reporting-CPA Practice Exam

What is hedging in relation to derivatives?

1. The practice of speculating on market prices

2. Using derivatives to manage anticipated losses

3. A method to increase earnings volatility

4. The act of eliminating all financial risk

The correct answer is: Using derivatives to manage anticipated losses

Hedging in relation to derivatives is primarily the practice of using these financial instruments to manage anticipated losses. When companies or investors engage in hedging, they are often looking to protect themselves from potential unfavorable movements in market prices, interest rates, or currency exchange rates that could impact their financial positions. By employing derivatives such as options, futures, or swaps, they create a counterbalancing position that can offset potential losses from these adverse movements. In this context, it's essential to distinguish hedging from speculation. Speculation involves taking risks on market movements in the hope of earning profits, which does not align with the primary goal of hedging. Additionally, while hedging reduces risk, it does not eliminate it entirely. Financial risks can never be completely eradicated; instead, hedging strategies aim to mitigate the impact of such risks on an entity's financial performance. Therefore, using derivatives primarily for loss management is the function that aligns with the definition of hedging.