Imagine you are managing a copper mine and plan to sell 800 metric tons of copper 3 months from today. Since you do not know the future price of copper, you are considering employing a put protection strategy to manage your price risk. A put option giving you the right to sell 1 metric ton of copper for $6.40 per kilogram 3 months from now costs $360. This is the option you want to use.
State the net cash position with and without the put protection, if the spot price of copper in 3 months’ time turned out to be:
Explain and show your workings
In the volatile world of commodities trading, managing price risk is crucial for businesses involved in the production and sale of raw materials. In this scenario, we will explore how a copper mining company can employ a put protection strategy to safeguard its revenues when selling 800 metric tons of copper three months from today. The put option in question grants the company the right to sell 1 metric ton of copper for $6.40 per kilogram in three months, at a cost of $360. We will analyze the net cash position both with and without this put protection, considering two different spot price scenarios: $5.10 and $6.80 per kilogram.
Before delving into the impact of the put protection strategy, let’s first calculate the net cash position without it for the two given spot price scenarios:
Revenue without put protection = 800 metric tons × $5.10/kg = $4,080,000
Cost of mining and production = (800 metric tons × $5.10/kg) × mining cost percentage
Net Cash Position = Revenue – Cost of mining and production
Revenue without put protection = 800 metric tons × $6.80/kg = $5,440,000
Cost of mining and production = (800 metric tons × $6.80/kg) × mining cost percentage
Net Cash Position = Revenue – Cost of mining and production
The exact mining cost percentage will depend on various factors like labor, equipment, energy costs, and operational efficiency. However, for this analysis, we will use a simplified percentage for illustration purposes.
With Put Protection: Now, let’s consider the net cash position with the put protection strategy for the two spot price scenarios:
i. Spot Price = $5.10 per kilogram
Revenue with put protection = 800 metric tons × $6.40/kg (put option strike price) = $5,120,000
Cost of put option = $360/ton × 800 metric tons = $288,000
Net Cash Position = Revenue with put protection – Cost of put option – Cost of mining and production
ii. Spot Price = $6.80 per kilogram
Revenue with put protection = 800 metric tons × $6.40/kg (put option strike price) = $5,120,000
Cost of put option = $360/ton × 800 metric tons = $288,000
Net Cash Position = Revenue with put protection – Cost of put option – Cost of mining and production
Analysis:
Spot Price = $5.10 per kilogram
Without Put Protection: Revenue – Cost of mining and production = $4,080,000 – (800 metric tons × $5.10/kg × mining cost percentage)
With Put Protection: Revenue with put protection – Cost of put option – Cost of mining and production = $5,120,000 – $288,000 – (800 metric tons × $5.10/kg × mining cost percentage)
Spot Price = $6.80 per kilogram
Revenue – Cost of mining and production = $5,440,000 – (800 metric tons × $6.80/kg × mining cost percentage)
With Put Protection: Revenue with put protection – Cost of put option – Cost of mining and production = $5,120,000 – $288,000 – (800 metric tons × $6.80/kg × mining cost percentage)
In both spot price scenarios, employing a put protection strategy has a significant impact on the net cash position of the copper mining company. It acts as a financial safety net, mitigating the risk of declining copper prices. The specific financial outcomes will depend on the actual mining cost percentage and the spot price at the end of three months. By using put options, the company can lock in a minimum selling price for its copper, ensuring a more predictable and stable cash flow, which is crucial for managing risk in the volatile commodities market. However, it’s important to note that the cost of the put option does reduce the overall profit potential, but it provides a valuable insurance against adverse price movements, allowing the company to focus on its core operations with greater confidence.
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