Hedging Price Risk with Options - Financial Management

In the previous examples, the hedges were effectively perfect because the long and short hedges that were put in place locked in the effective purchase price (the long hedge) and selling price (the short hedge) for copper. Reconsider the case of Battle Mountain Copper Company and its plans to sell 50,000 pounds of copper to Ford Motor Company in late May 2004. Earlier, we showed what would have happened to Battle Mountain if the price of copper had declined between February 24, 2004, and May 24, 2004. The losses the company would have experienced in the cash market were offset by gains in the futures market. But what if the price of copper had risen during that time period from 132.85 cents per pound to 160 cents per pound? The managers who set up this hedge might have had a tough time explaining to their superiors why the company was only getting 132.85 cents per pound instead of the 160 cents price that was prevailing in May.

Is it possible for Battle Mountain to protect itself against price declines and at the same time be in a position to benefit from price increases? The answer is yes, but this type of onesided insurance comes at a price. Recall from the previous chapter that a call option gives the buyer the right to purchase something, such as a share of stock or an amount of copper, at the exercise price of the option up until the time the option expires (in the case of American options), or at expiration(in the case of European options). Similarly, a put option gives the buyer the right to sell something at the exercise price of the option up until the time the option expires (in the case of American options), or at expiration (in the case of European options). Which option should Battle Mountain use in this example? Because Battle Mountain wants to sell copper to Ford Motor, it should buy put options on copper with an expiration date in May 2004.

Recall also from our discussion of options that, unlike futures contracts, options require the payment of a premium that is dependent on several factors, including the time remaining to expiration, the level of interest rates, and the volatility of the underlying asset(in this case, the price of copper). Suppose a May put option is available for copper with an exercise price of 132 cents per pound and the price of that option (the premium) is 6.65 cents per pound. If the price of copper rises from an expected level of 132.85 cents to 160 cents, Battle Mountain would simply let its put options on copper expire and sell the copper to Ford for 160 cents per pound. But if the price declined to 120 cents per pound, Battle Mountain could exercise its put options and sell the copper at the exercise price of 132 cents per pound.

This one-side protection comes at a price, however, and that price is the option premium of 6.65 cents per pound paid when the option was purchased. illustrates the profits and losses from the option strategy discussed here.

It is apparent in this table that the options hedging strategy allows Battle Mountain to benefit from price increases, and it provides protection from price declines. There is a cost to this protection, however, and that cost is the option premium, which in this case was 6.65 cents/pound.

Final Comments Regarding Risk Management Strategies

This chapter has provided a brief introduction to some of the risk management strategies available to managers who want to reduce or eliminate some of the important operating and financial risks facing them. Risk is one of the most important variables that managers must deal with as they seek to maximize shareholder wealth. Choosing the proper risk management techniques can make the difference between success and failure. The discussion in this chapter has just scratched the surface of this important topic. In advanced courses, you will learn how a wide range of financial derivatives can be used to help manage a wide variety of risks, from currency risks, to interest rate risks, and various aspects of pricing risk.

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