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CFA Level I · CFA Level I Exam · Introduction to Risk Management

An airline expects to buy large volumes of jet fuel next year and enters forward contracts to fix the price. Compared with buying insurance, the hedge is most likely to:

The forward hedge removes the risk of rising fuel prices but also forfeits gains if prices fall, because the price is fixed either way. Keeping the benefit of lower prices would require an option-type instrument with an upfront premium, as insurance does.

  1. ARemove downside price risk and also forgo gains if fuel prices fallCorrect
  2. BRemove downside price risk while keeping the full benefit of any fuel price decline
  3. CLeave the airline exposed to rising fuel prices but protect it from falling prices

Explanation

A forward locks in the price, so the firm is protected if prices rise but also gives up the benefit if prices fall; it is a two-sided transfer. Keeping the benefit of falling prices would need an option-like instrument or insurance with a premium. The third option reverses the exposure direction.

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