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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A shareholder argues that a gold mining company should not hedge its gold price exposure because investors can diversify on their own. Which condition would most weaken this argument in favor of hedging by the firm?

The argument is weakened when the firm faces costly financial distress and investors cannot cheaply replicate the hedge. These market imperfections break the Modigliani-Miller irrelevance result, so firm-level hedging can add value that individual investors cannot obtain on their own.

  1. AInvestors hold well-diversified portfolios and have perfect information about the firm
  2. BCapital markets are perfect with no taxes or transaction costs
  3. CInvestors cannot cheaply replicate the firm's hedge and the firm faces costly financial distressCorrect
  4. DThe firm's gold price exposure is perfectly correlated with the market portfolio

Explanation

Under Modigliani-Miller conditions, hedging is irrelevant because investors can hedge themselves. Market imperfections such as distress costs and the firm's cost advantage in hedging make firm-level hedging valuable. The other options describe conditions where hedging is irrelevant or do not address imperfections.

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