Question

Please attempt both questions for thumbs up

a) A gold mining firm that produces gold will have gold ready for sale and delivery in 6 months from now, but expects or forecasts that prices will fall within the next 6 months and would like to lock into the current price as closely as possible to manage its revenue and operating profit margin. Set up a trading strategy using futures contracts only considering the information provided in table below:

Time

Cash Market Price of Gold per unit

Futures Market Price of Gold per unit

Now	$1223 Cash or Spot price	$ 1225 Futures price
Later:6 months from now	$1219 Cash or Spot price	$1221 Futures price

Show your work and actions in table below

Time	Actions in the cash or spot market	Actions in the futures market
Now
Later: 6 months from now
Results

Show the combined results of your actions and calculate the net, actual, final result in dollars per unit to the gold producer below here.

b) You are considering the sale of a call option with an exercise price of $ 150 and one year to expiration. The underlying stock pays no dividends, its current price is $152 and you believe it has a chance of rising to $ 156 and a chance of falling to $ 144. The risk-free rate of interest is 5%. Compute the call option’s fair value (equilibrium price) by applying the binomial (two-sate) option pricing model.

Answer 1

(a) The gold mining firm is long on the gold as a price drop is harmful to its interests. As the firm is long on the underlying asset (gold), the firm should go short in the futures market to hedge against a price drop. The hedge would be executed as given below:

- Sell one futures contract now.

- 6 months later sell gold at the spot market rate and square off futures position by buying one futures contract at the then prevailing futures market price.

Loss in the Spot Market = 1219 - 1223 = - $ 4 per unit

Gain in the Futures Market = $ 1225 - 1221 = $ 4 per unit

Net Gain/Loss = Gain in Futures Market + Loss in Spot Market = 4 - 4 = $ 0

NOTE: Please raise a separateq query for the solution to the second unrelated question.