Question

PROBLEM 4 Edward's Tequila Corporation is worried about the volatility in the price of agave, the plant used to make tequila. The company would be in deep trouble if the price of agave were to skyrocket, which would severely cat into their profits. Explain how they should hedge against the adverse price motion? Note that their investment portfolio may consist of govern- ment bonds, the company stock, forward contracts or options to buy or sell agave at a specific price at a set date in the future, and swaps. Explain in detail.

Answer 1

For price protection at a minimal outlay and without blocking much margin, the company can buy a call option on agave. This would give the company the right but not the obligation to buy the required amount of agave at a future date (the expiry date of the contract).

This also caps the downside in case agave actually goes down, in which case the company can let the option expire worthless, while capping its maximum loss at the premium that it paid to buy the call option. The company can rollover the contract near expiry to make sure it doesn't stand exposed to the price movements again once the running month contract expires. This arrangement gives constant hedge against the delta of the underlying, i.e. agave in this case.