Question

Easton Ltd is a company specialising in the brewing of a style of beer called IPA. A key ingredient in IPA is a type of hops called Simcoe Hops. Simcoe Hops is currently traded in the market for $20 per kilo It is January 2019 and you have been engaged by Easton Ltd to provide them with advice on how they might manage their exposure to the cost of hops when they next need to buy them in May 2019. The Chief Financial Officer (CFO) of Easton Ltd tells you that hops prices are notoriously volatile and she would like to understand how the use of options might assist her company in managing that risk. (a) Advise the CFO what style of option Easton Ltd should consider purchasing (that is, a put or call) and why that is the case. (b) Show - using a payoff diagram - the payoffs from the style of option selected in part (a) - assuming that that option had an exercise price of $22 per kilo. Also, include the payoff from an unhedged position (no need to use Excel here - just label turning points and intercepts (if any)) (c) Now show - using a payoff diagram - the payoffs for Easton Ltd in terms of the cost they face in May 2019 (per kilo) for their hops if they hedge using the option described in (a) and (b) (d) Explain the circumstances- if any under which Easton Ltd will be worse off (overall) if they hedge using the options described above as compared with not hedging at all. Demonstrate this graphically. For the sake of the illustration - assume that the option described above cost $1 to buy.

Answer 1