Question

You = gold producer, worried about the gold prices in the future. In May , you buy six September gold futures contracts (short position) of 100 ounces each, with an exercise price of $860.00 per ounce. Ignore transaction costs.

i)profit/loss be for your entire position, if gold prices turn out to be $900 per ounce at expiration?

ii) profit or loss be for your entire position if gold prices turn out to be $820 per ounce at expiration?

iii) Based on your answer to question (i) and (ii) were you right or wrong to get the future contract? What is the main benefit you get from hedging your selling price?

iv) What would the profit or loss be for your entire position if you had a put option, instead of a futures contract, with a strike price of $860 per ounce, and the price turns out to be $900 per ounce at expiration?

v) State one advantage and one disadvantage of an option contract when compared to a futures contract?

Answer 1

Solution :

Short position on 6 future gold ( 100 ounce per contract ) at 860

i)profit/loss be for your entire position, if gold prices turn out to be $900 per ounce at expiration?

Since current future price is 900 so the producer will lose because he has sold at 860 and now price is 900

Total loss = No of contaract * Ounce per contract * loss per ounce = 6 * 100 * (900- 860) = 600 * 40 = 24,000

ii) profit or loss be for your entire position if gold prices turn out to be $820 per ounce at expiration?

Since current future price is 820 so the producer will gain because he has sold at 860 and now price is 820

Total loss = No of contaract * Ounce per contract * gain per ounce = 6 * 100 * (860-820) = 600 * 40 = 24,000

iii)

Decision was wrong in case of i)

Decision was right in case of ii)

Benefit of hedging by selling the future is that you have sold at price 860 and if price goes down then you will get be at profit

iv)

Had he purchased the put option and if the price goes above the exercise price then he has right to not exercise the option and sell in the cash market at $900. Buying a put option gives right but there is no obligation. only thing the producer can lose is the premium paid on the option

V)

The advantage of the put option: Put option gives the right but there is no obligation. So if price moves in the favor then one can exercise and if it moves against then there is no obligation

Disadvantage: In order to make the option exercisable it has to cross the certain exercise price. You need to pay a premium depending on the exercise price so there is an upfront cost and it can't be recovered if the price doesn't move in the required direction