CFA Practice Question

CFA Practice Question

______ is the purchase or sale of futures as a temporary substitute for a transaction in the cash market.
A. Arbitraging
B. Hedging
C. Speculating
Explanation: Hedgers are often producers or major users of a given commodity who trade futures to reduce some preexisting risk exposure.

User Contributed Comments 5

User Comment
andrewsutton Help. The explanation is obviously true, but how does it relate to the question?

(here's my (incorrect) line of thinking. Can anyone tell me why it is incorrect?: a 'transaction in the cash market' means buying or selling cash, i.e. borrowing or lending. *Anything* done as a substitute for this - I assumed that substitute meant equivalent - must also be a form of borrowing or lending. Hence I chose B.)
jayjunk Suppose you have decided to purchase a stock, but can only do it a week from now. The price of the stock can change during the week, thus you are exposed to "risk". You can get rid of this risk by entering a futures contract. Getting rid of risk is referred to as "hedging".
wollogo I think that by transaction in the cash market they maen the actual physical market for the asset (doesnt just mean cash), the time frame is the point of difference. Cash implies transactions now - Futures implies transactions in the future. Thats my take anyway.

Don't really agree with the answer - I would say that abitraging would be using the futures market to take advantage of 'temporary' differences with the cash market. That is what makes the futures market efficient and is a more correct interpretation in my book.
steved333 Arbitrage, however is generally referring to an immediate transaction that will very quickly take advantage of already existing temporary differences. Taking advantage of those differences over a period of time is speculation, no? But substituting for a cash transaction suggests that you are not trying to earn a profit, but rather you are trying to buy time without losing a deal, which would be hedging.
dlukas Jayjunk, getting rid of risk is not always hedging (e.g., adding securities with minimally correlated returns to diversify a portfolio isn't hedging). It's only hedging if you purchase assets whose returns are negatively correlated, so losses in one are offset by gains in another.
You need to log in first to add your comment.