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

Which of the following is the most likely reason a publicly listed firm's managers, rather than its diversified shareholders, might favor hedging company-specific risks?

Managers often have their human capital and wealth concentrated in the firm, so they cannot diversify away firm-specific risk and prefer it hedged. Diversified shareholders are not compensated for idiosyncratic risk and would not demand this.

  1. AManagers' human capital and wealth are concentrated in the firm, making them risk averse to firm-specific volatilityCorrect
  2. BDiversified shareholders pay a higher risk premium for idiosyncratic risk
  3. CHedging always raises expected earnings per share
  4. DRegulators require all listed firms to hedge all exposures

Explanation

Managers typically cannot diversify their human capital and often hold substantial firm equity, so they bear firm-specific risk and prefer it reduced. Diversified shareholders do not require compensation for idiosyncratic risk, hedging does not guarantee higher expected EPS, and no such blanket regulation exists.

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