Which investment strategy involves deliberately taking on a new risk to offset an existing one?

• A. Hedging
• B. Arbitrage
• C. Asset allocation
• D. Diversification

Answer: (A)

Hedging is a strategy built to reduce or neutralize risk by taking on a position that moves in the opposite direction to an existing exposure. The idea is to offset potential losses with gains from the new bet, so the overall risk profile is lower even though you’ve introduced another market bet. For example, if you own a stock and worry about a price drop, you can buy a put option or enter a futures contract that gains when the stock falls; the payoff from the hedge helps cushion the loss on the stock. Similarly, a company with exposure to exchange rates can lock in a future rate using forwards or options, turning currency risk into a more predictable outcome. This approach focuses on protecting against downside rather than simply spreading bets around, which is what diversification or asset allocation aims to do on a broader portfolio level. Diversification reduces risk by holding a mix of assets, but it doesn’t deliberately create an offsetting position against a specific risk. Arbitrage seeks to exploit price inefficiencies with little to no risk, not to offset a preexisting exposure. Hedging is the deliberate creation of a counteracting risk to protect against adverse movements, even though it may cap upside or incur costs.