why hedging with derivatives is costly?

CFAI online practice question - Harlow Choate Case Scenario

Consideration 3: It is difficult to hedge tail risks through portfolio diversification, and it can also prove too costly. We prefer to hedge using such derivatives as credit default swaps, which have a very low cost.


Consideration 3 is incorrect. Hedging tail risks through portfolio diversification is not difficult to implement and only has modest incremental cost. Hedging with derivatives, such as credit default swaps, is effective but costly.

Credit default swaps involve monthly payment of premiums in addition to the initial value you pay to buy. Plus they’re illiquid instruments which just adds up to the overall cost in transacting in them.