Question

In: Finance

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

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. The firm is considering two hedging choices: futures contracts and option contracts. Suppose that the firm decides to hedge using futures contracts. Should it buy or sell futures contracts? Explain.

Solutions

Expert Solution

The firm should buy Future contracts in order to hedge the risk of rising price of silver.

Reason-

A futures contract is a contract between two parties where both parties agree to buy and sell a particular asset of specific quantity and at a predetermined price, at a specified date in future

The manufacturer uses silver as raw material in production process.It is afraid of silver prices rising.On buying a Future contract on silver,the firm locks up a price today at which silver can be purchased by the firm at a future date (maturity date of future contract).Hence even if there is rise in silver price at a future date, the firm can buy silver at lower contracted rate (rate at which future contract is purchased today) at future date (when the actual silver rate is high)

Therefore the firm should buy future contract for hedging silver price hike risk.

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