GF561 Unit 5 Copper Producer Option Strategy Case Example

Lock, Floor, Band or Partial Floor: A Unit 5 Option Strategy Case for a Copper Producer's Next Quarter

[Student Name]

Purdue University Global

GF561: Derivatives and Hedging

Unit 5 Option Strategy Case

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[Date]

The producer and every price are composite and illustrative, with options valued by Black's model; the articles and textbook cited are real.

The Producer and Its Exposure

The producer runs a mid-sized open-pit mine and expects to sell six million pounds of copper cathode over the next three months, priced at the average of the three-month futures contract. The futures price is now $4.20 a pound. The mine's all-in cost to produce is about $3.70 a pound, and its lenders require that quarterly revenue cover interest and scheduled principal of about $3 million with room to spare. A fall to $3.40 would leave the mine selling below cost.

Market Inputs

Three-month copper futures: $4.20. Implied volatility: 24 percent a year. Risk-free rate: 4.2 percent. Options on futures are valued with Black's model, which treats the futures price as the underlying and discounts the expected payoff at the risk-free rate (Black, 1976). Each futures contract covers 25,000 pounds, so six million pounds equals 240 contracts.

Choice 1: Sell Futures

Selling 240 contracts at $4.20 fixes revenue near $25.2 million whatever happens to copper, apart from basis differences between the mine's sales and the futures. It costs nothing upfront but gives away every gain if copper rises, and it requires cash for daily margin if prices rise during the quarter.

Choice 2: Buy Puts at $4.00

A three-month put struck at $4.00 costs about $0.111 a pound, or about $666,000 in total. It sets a floor of $4.00 a pound, or about $3.89 after the premium, while keeping all gains above $4.00.

Choice 3: A Zero-Cost Collar

Buying the $4.00 put and selling a call struck at about $4.43, worth almost exactly the same $0.11, costs nearly nothing. The producer's price is confined to a band: no lower than $4.00 and no higher than $4.43.

Choice 4: A Put Spread

Buying the $4.00 put and selling a $3.60 put costs about $0.089 a pound, $535,000 in total. It protects only between $4.00 and $3.60; below $3.60, the producer is exposed again, one dollar for one dollar.

The Decision Table

Revenue for six million pounds, net of option costs, in millions of dollars, at five average prices:

1. At $3.40: unhedged $20.40; futures $25.20; puts $23.33; collar $24.00; put spread $22.26.

2. At $3.80: unhedged $22.80; futures $25.20; puts $23.33; collar $24.00; put spread $23.46.

3. At $4.20: unhedged $25.20; futures $25.20; puts $24.53; collar $25.20; put spread $24.66.

4. At $4.60: unhedged $27.60; futures $25.20; puts $26.93; collar $26.58; put spread $27.06.

5. At $5.00: unhedged $30.00; futures $25.20; puts $29.33; collar $26.58; put spread $29.46.

Reading the Table

Futures give the narrowest range, a single number, but no upside. Puts keep nearly all the upside at a cost of $666,000 in every outcome. The collar costs nothing and guarantees at least $24.0 million but caps revenue at $26.6 million. The put spread is cheapest of the paid choices but fails in exactly the outcome that worries the producer most: at $3.40 it delivers only $22.3 million, little better than not hedging at all.

The put spread looks like a cheaper put, but it removes protection in the deep-loss outcome the mine most needs to survive, so it saves money on the scenarios that matter least and fails on the one that matters most.

Matching the Choice to the Producer

Three facts about this producer decide the choice. First, a price near $3.40 would put the mine below its $3.70 cost and threaten its loan covenants, so the floor matters more than anything else. Second, the board is reluctant to pay $666,000 for protection in a quarter when prices may well hold. Third, the mine's cash reserve is modest, so the daily margin calls that a futures position would demand in a rally are a real burden.

The collar satisfies all three. It guarantees a price above cost, costs nothing upfront and, because the producer buys the put and sells the call, any margin needed on the short call arises only if copper rises above $4.43, when the mine is earning more on its physical sales. Research on how producers manage commodity risk finds that firms facing costly financial distress hedge more and favor strategies that protect downside without large upfront costs (Tufano, 1996).

What the Collar Gives Up

If copper averages $5.00, the collar leaves about $3.4 million on the table compared with the puts. The board should accept that before signing: the collar trades the chance of a very good quarter for certainty that the quarter will not be very bad.

Sensitivity to Volatility

If implied volatility rose from 24 to 30 percent before the trade, the put would cost about $0.156 a pound, roughly $938,000 in total, while the zero-cost call strike would barely change, because the call's value rises by almost the same amount. Higher volatility therefore makes buying puts outright noticeably dearer while leaving the collar's band almost where it is (Hull, 2022).

Basis and Timing Risk

None of the four choices removes every risk. The mine sells at a monthly average price, while the options settle on the futures price at expiry, so a sharp move in the final weeks of the quarter could leave the hedge and the sales out of step. The mine's cathode also sells at a premium or discount to the exchange contract depending on quality and location, which the hedge does not cover. Both risks are small relative to the price risk being hedged, but the board should know they remain.

Reporting the Hedge

If the collar is designated as a cash flow hedge under the accounting standard, changes in its value will be held in other comprehensive income and released to earnings when the copper is sold, so the hedge does not create swings in reported profit before the sales occur. Documentation must be in place at the start of the hedge for that treatment to apply. Without it, changes in the collar's value would run through earnings each quarter, which could confuse lenders reading the mine's results.

A Note on Counterparties

Exchange-traded options on copper futures clear through the exchange, so the producer faces little counterparty risk on the collar. If the board preferred an over-the-counter collar matched exactly to the monthly average price, it would take on the bank's credit risk in exchange for removing the timing mismatch described above.

Recommendation

Enter a zero-cost collar on six million pounds: buy 240 three-month puts at $4.00 and sell 240 calls at about $4.43. Review the strikes at each quarter's start, and revisit puts outright if the board's view on copper turns strongly upward.

References

Black, F. (1976). The pricing of commodity contracts. Journal of Financial Economics, 3(1-2), 167-179. https://doi.org/10.1016/0304-405X(76)90024-6

Hull, J. C. (2022). Options, futures, and other derivatives (11th ed.). Pearson.

Tufano, P. (1996). Who manages risk? An empirical examination of risk management practices in the gold mining industry. The Journal of Finance, 51(4), 1097-1137. https://doi.org/10.1111/j.1540-6261.1996.tb04064.x