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18/19 A large dental lab plans to purchase 1000 ounces of gold in 1 month. Gold...

18/19

A large dental lab plans to purchase 1000 ounces of gold in 1 month. Gold currently sells for $420 an ounce, but the price is extremely volatile and could fall as low as $400 or rise as high as $460 in the next month.

The futures price of gold for 1-month-ahead delivery is $440. If the firm decides to hedge its risk by using futures contract, should the firm buy or sell such contracts? Please answer "buy" or "sell" in the box

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Answer #1

The firm has to buy the gold. So it is worrying that the price can rise up to 460. To hedge this risk, it needs to buy the futures contract so that it can buy the gold at 440. If the price rises higher than 440 then the lab gains as it can buy the gold at 440 as per the futures contract. But if the price falls below 440, then the firm loses bescause it still has to buy it at 440. But as there is chance of the price of goldgoing in either direction and the lab has to buy the gold, so it is best to hedge it buy buying the futures contract.

If it sells the futures contract, then it will have to sell gold at 440, but that wont solve its purpose because it needs gold and not sell it.

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