Answer to Question #125722 in Finance for Thapelo

Question

5) Your firm is one of the largest bakery’s in the area. As part of your risk management process, you are considering using options to hedge the price risk on your biggest input – wheat. You have determined that a price of R52/per ton would allow for you to keep the same profit margin as last year. The following wheat options offer a strike price of R50/per ton expiring in 1 month:
▪ Call options on wheat are selling at a premium of R0.87 per ton.
▪ Put options on wheat are selling for R0.72 per ton.
(a) Given the information above, will you need need a call or a put option? ​ [1 mark]
(b) If each option is for 100 tons, and you require 1000 tons of wheat, demonstrate the outcome if, at expiry, the spot price of wheat is (i) R40 per ton and (ii) R60 per ton.

Answer 1

Options are derivative contracts involving two parties (buyer of the contract and seller of the contract.

They are of two types namely:

Call options: which gives the buyer of the contract an option (not an obligation) to buy the underlying asset at a fixed price called the strike price at a fixed date in the future (maturity of the option).

Put options: which gives the buyer of the contract an option (not an obligation) to sell the underlying asset at a fixed price called the strike price at a fixed date in the future (maturity of the option).

A)  Selection between call or put option: Here, the company wishes to lock in the purchase price of wheat since it is an input. Therefore, the company must opt for the Call option so that it can purchase wheat in the future at the option's strike price.

B) Please note that the option will be exercised only if the price of wheat at maturity is above the strike price of $\text{R50/}$ ton because in that case the company will be able to purchase wheat at the strike price, which is lower than the market price of wheat. If instead, the market price of wheat is lower than the strike price, the company will simply want to purchase wheat at the market price itself and the option will expire worthless.

If the spot price at expiry is $\text{R40/}$ ton, the company will not exercise its option and Company will let the option expire.

If the spot price at expiry is $\text{R60/}$ ton, the company will exercise the option and be in a profitable situation:

$\text{Option Purchased: 1000 tons x R50 per ton (strike price) + 1000 tons x R0.87 per ton (option premium) = R50,870}$ $\text{Spot Price: 1000 tons x R60 = R60,000}$

$\text{Profit: 9,130}$