Which one of the following four strategies could the bank use to offset the risk from its current exposure to aluminum as it sets the price for selling the commodity in four-months’ time?

Using a forward transaction, Omega Bank buys 100 metric tones of aluminum for delivery in six-months’ time. However, after two months, the bank becomes concerned with the potential fluctuations in aluminum prices and wants to hedge its potential exposure against a possible decline in aluminum prices.

Which one of the following four strategies could the bank use to offset the risk from its current exposure to aluminum as it sets the price for selling the commodity in four-months’ time?
A . Sell an aluminum futures contract
B . Buy an aluminum futures contract
C . Sell an aluminum forward contract
D . Buy an aluminum forward contract

View Answer

Answer: A

Explanation:

To hedge against potential declines in aluminum prices, Omega Bank should take a position that benefits from a price drop.

Here are the steps and strategies:

Current Position:

Omega Bank has bought 100 metric tons of aluminum for delivery in six months.

Hedging Strategy:

To protect against a decline in aluminum prices, the bank should take a short position in the aluminum futures market. This involves selling aluminum futures contracts.

Execution:

By selling an aluminum futures contract, Omega Bank locks in a price for selling aluminum in the future, thus offsetting the risk of price declines.

The correct strategy is to sell an aluminum futures contract, which effectively hedges the bank’s exposure to a potential drop in aluminum prices.

References Source: How Finance Works?