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

Question

3. 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

The manufacturer needs to acquire silver so will purchase silver futures to offset higher production costs should silver prices rise in the spot commodity market. Since there is an ongoing need, it is likely the manufacturer will maintain a continuous position in the silver futures market. The firm in this case hopes to insulate itself from fluctuations in the price of silver, thereby maintaining a more predictable stream of production cost cash outflows.

Related Questions

Navigate

• Browse (All)
• Browse 3
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.