General Securities Representative (Series 7) Practice Exam

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What represents the best hedge against systematic or market risk?

  1. Equity shares

  2. Real estate investments

  3. Index options

  4. Commodity futures

The correct answer is: Index options

The best hedge against systematic or market risk is represented by index options. Systematic risk, also known as market risk, affects the entire market or a particular segment of it, making it impossible to eliminate through diversification alone. Index options specifically allow investors to protect themselves against declines in a particular market index, which reflects the overall performance of a market or sector. When an investor holds index options, they gain the right, but not the obligation, to buy or sell an index at a predetermined price by a specific expiration date. This ability to maneuver based on market movements makes index options a powerful tool for hedging against potential losses from downturns in the market. They allow investors to offset losses in other investments that are adversely affected by market fluctuations, thus serving as an effective hedge. Other financial instruments mentioned, such as equity shares, real estate investments, and commodity futures, can contribute to diversifying a portfolio or offer potential returns; however, they do not provide the same direct counterbalance to systematic risk that index options do. Equity shares can lose value during a market downturn due to their inherent exposure to market volatility. Real estate investments may also suffer in a broader economic downturn. Commodity futures, while they may respond differently to market conditions, do not directly correlate