In 1979 and 1980, the Hunt brothers from Texas attempted to corner the world’s silver market. Their hope was to own enough silver to be able to dictate world prices. They made purchase commitments, which locked in the price they would pay for silver. For a while, their plan worked. The price of silver rose, and the Hunt brothers used the silver they owned as collateral to purchase more silver. Their plans were shattered when the price of silver started to decline. From a high in January 1980 of $50.35 an ounce, the price of silver fell to $10.80 in just two months. The silver they were using as collateral decreased in value, requiring the Hunt brothers to provide additional collateral. This collateral was in the form of oil, sugar, and real estate, each of which was faring poorly at the time of the silver crash. At the same time, the purchase commitments they had made required them to buy silver at prices higher than the current market value of silver. The Hunt brothers sought protection in bankruptcy court, and the scheme eventually cost them approximately $4 billion.
1. What are the risks associated with making purchase commitments?
2. Why do accounting standards require that price declines subsequent to the purchase commitment but prior to the actual purchase be recorded immediately?
3. Can firms take any action to reduce their exposure to changing prices?