Question

Suppose you are advising a firm that operates a copper mine that faces the following types of risks. The firm is asking for your opinion to buy or sell derivatives contracts to hedge its underlying operations or financial risk. For each risk type listed below, recommend a call or put option for the firm. Briefly justify your reasoning.

A. Exposure to interest rates if the firm is planning to borrow $20 million 12 months from today.

B.Exposure to an upcoming purchase from a supplier in the UK, for which the firm is expected to pay £10 million in 12 months from today. The firm's operating costs are denominated in USD.

C.Exposure to global copper prices, which directly determines the firm's earnings.

Answer 1

A. Interest rate risk exists in an interest-bearing asset, such as a loan or a bond, due to the possibility of a change in the asset's value resulting from the variability of interest rates. Interest rate risk management has become very important, and assorted instruments have been developed to deal with interest rate risk. Interest rate risk is the risk that arises when the absolute level of interest rates fluctuate. Interest rate risk directly affects the values of fixed-income securities. Corporations who need to borrow at some point in the future and want to insure or hedge against adverse changes in interest rates during the interim will buy an "Interest Rate Call Option". Interest rate call options can be used by an investor wishing to hedge a position in a loan in which interest is paid based on a floating interest rate. By purchasing the interest rate call option, an investor can limit the highest rate of interest for which payments would have to be made while enjoying lower rates of interest, and she can forecast the cash flow that will be paid when the interest payment is due.

B. A currency option (also known as a forex option) is a contract that gives the buyer the right, but not the obligation, to buy or sell a certain currency at a specified exchange rate on or before a specified date. For this right, a premium is paid to the seller. Currency options are one of the most common ways for corporations, individuals or financial institutions to hedge against adverse movements in exchange rates.

As the supplier is based in UK and the firm needs to pay 10 million pounds in 12 months time, the US based firm should lock in the furture payment rate. This can be done by using a "Currency call option" which will give the firm the right to buy the currency at a favourable rate if market is not so favourable.

C. The price of copper is determined primarily by the ability of copper suppliers to extract and transport the product, as well as the demand for goods and services that require copper. Other broad factors include interest rates, economic growth, the availability and attractiveness of substitute goods, and political considerations. Copper prices dropped dramatically towards the end of 2008 during the height of the financial crisis and the decline of the housing market. This tie to housing meant that copper struggled more than most metals, such as gold and silver, during the recession. The high rate of global copper consumption requires a high level of ongoing production. Profitable extraction depends on a large number of variables: government tax rates and regulations, inflation levels, labor wage rates, effective management of copper extraction and production firms, and cost-efficient mining techniques.

Copper producers can hedge against falling copper price by selling a "Copper Put Option" to lock in a future selling price for an ongoing production of copper that is only ready for sale sometime in the future.