Question

25)   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.   [12 marks].

Answer 1

a) Here firm is the importer/buyer of wheat, to hedge the price risk using options, the firm must buy call options which give the right but not the obligation to purchase the asset at a pre specified price

b) No of call options to be bought = 1000 tons/ 100 tons per option = 10 call options

Total premium of call options = R0.87/ton *1000 tons = R870

i) If the spot price of wheat is R40 / ton after one month :-

The firm will let the call options lapse and purchase the wheat from the market at R40/ton

Total value paid by the firm =R40*1000 + R870 = R40870 for 1000 tons ,

Therefore net price per ton of wheat to firm= R40.87/ton

ii) If the spot price of wheat is R60 / ton after one month :-

the firm will exercise the call options and purchase the wheat at R50/ton

Total value paid by the firm =R50*1000 + R870 = R50870 for 1000 tons ,

therefore net price per ton of wheat to firm= R50.87/ton (which is the maximum price the firm has to pay)