Question

Assume that there is no storage or other carrying costs/value for corn. Assume that corn is not perishable, that is it can be stored and used later and that the continuous compounded risk-free rate is 20% per year.

While the manufacturer does like to be hedged against the risk from rising corn prices, they are concerned if corn prices fall they will suffer large losses as their competitors (who are un-hedged) will undercut them.

What can the manufacturer do about this? Explain the advantages and disadvantages of your chosen strategy. Be specific in your description of the strategy/instruments used.

Answer 1

The strategy that the manufacturer can take is to purchase Call options on Corn which will cost very less and which will protect the manufacturer from rising prices as well as let the manufacturer benefit from the decrease in prices thereby maintaining its competitive position. The advantage of this strategy is that benefits of both sides can be obtained. The disadvantage is that an initial premium has to be paid which is not refundable.

The call options have a payoff = max (St-K,0)

i.e. the call options give a profit = Corn price at maturity less strike price when corn price increases beyond strike price and 0 otherwise, Thus the manufacturer can have an advantageous position in both cases