# Question

Suppose that price and quantity are positively correlated as in this table:

There is a 50% chance of either price. The futures price is $2.50. Demonstrate the effect of hedging if we do the following:

a. Short the expected quantity.

b. Short the minimum quantity.

c. Short the maximum quantity.

d. What is the hedge position that eliminates variability in revenue? Why?

•XYZ mines copper, with fixed costs of $0.50/lb and variable cost of $0.40/lb.

•Wirco produces wire. It buys copper and manufactures wire. One pound of copper can be used to produce one unit of wire, which sells for the price of copper plus $5. Fixed cost per unit is $3 and noncopper variable cost is $1.50.

•Telco installs telecommunications equipment and uses copper wire fromWirco as an input. For planning purposes, Telco assigns a fixed revenue of $6.20 for each unit of wire it uses.

The 1-year forward price of copper is $1/lb. The 1-year continuously compounded interest rate is 6%. One-year option prices for copper are shown in the table below.17

In your answers, at a minimum consider copper prices in 1 year of $0.80, $0.90, $1.00, $1.10, and $1.20.

There is a 50% chance of either price. The futures price is $2.50. Demonstrate the effect of hedging if we do the following:

a. Short the expected quantity.

b. Short the minimum quantity.

c. Short the maximum quantity.

d. What is the hedge position that eliminates variability in revenue? Why?

•XYZ mines copper, with fixed costs of $0.50/lb and variable cost of $0.40/lb.

•Wirco produces wire. It buys copper and manufactures wire. One pound of copper can be used to produce one unit of wire, which sells for the price of copper plus $5. Fixed cost per unit is $3 and noncopper variable cost is $1.50.

•Telco installs telecommunications equipment and uses copper wire fromWirco as an input. For planning purposes, Telco assigns a fixed revenue of $6.20 for each unit of wire it uses.

The 1-year forward price of copper is $1/lb. The 1-year continuously compounded interest rate is 6%. One-year option prices for copper are shown in the table below.17

In your answers, at a minimum consider copper prices in 1 year of $0.80, $0.90, $1.00, $1.10, and $1.20.

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