Suppose that a manufacturer has an ongoing need for silver as a raw material in

Question

Suppose that a manufacturer has an ongoing need for silver as a raw material in the production process, and is concerned about the risk of the price of silver going up. Two hedging choices being considered are futures contracts and options.

First, explain whether this firm should

(i) buy or sell futures contracts

(ii) use call or put options and whether the firm should buy or sell them.

Second, discuss the advantages and disadvantages of hedging using options as compared to futures contracts. (20 points)

Explanation / Answer

(i)

Since the manufacturer needs silver it has to buy Silver. Future contract is a agreement where buyer/ seller agree to buy/sell in future period at price set on the day of agreement. If manufacturer buys a future contract then manufacturer agrees to buy silver at set price on future period.

Since manufacturer wants to avoid risk of price of silver going up, it should buy future contract.

(ii) Options is a contract that provides its holder a right but not obligation to perform certain transaction at a set price in future period

Call option provides its holder the right to purchase specified asset in future at set price. Holder is not obliged to purchase.

Put option provides its holder the right to sell specified asset in future at set price. Holder is not obliged to sell.

Manufacturer should use Call option since it wants to purchase Silver.

Advantage of option over future:

1. Provides right but not the obligation. Under future holder is obliged to perform the future.

2. Trading option contracts is less risky than trading futures contracts, because buying call or put options does not obligate holder to buy or sell assets

3. Unlike future contracts, holder know the price of trading an option before holder invest any money.Holder can profit in more than one way by trading option contracts. If the contract is deemed profitable when the contract expires, holder can buy or sell the underlying assets for a profit or holder can sell the option contract to another investor for a profit.

Disadvantage of options:

1. Option are relatively more costly than future.

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