Page 101 - DCOM510_FINANCIAL_DERIVATIVES

Financial Derivatives

Notes 14. The Black-Scholes formula is a mathematical formula for the theoretical value of so-called
European put and call stock options that may be derived from the assumptions of the
model.
15. The binomial tree represents different possible paths that may be followed by the stock
price over the life of the option.



Case Study Protection Against Rising Raw Material Costs

f rising commodity prices is a risk to your profitability, buying call options will help
you. It allows you to establish a maximum purchase price without giving up the
Iopportunity to profit from falling prices. For example, suppose you’re a refiner and
you expect to buy soybean oil in next few months. You are worried that prices may rise.

You would like to establish a ceiling price for your purchase. So, you buy a May soy oil
call with a ` 450 strike price. This gives you a maximum purchase price of ` 450 per 10 kg
(excluding basis, commissions, and the cost of the option). If, in April, the May futures
price increases to ` 490 your call option becomes in the money. Now you can exercise your
option and receive a long futures contract at the ` 450 strike price.
Selling back the futures contract at the higher market price ` 490 per 10 kg gives you a
profit of ` 40 per 10 kg, which should roughly offset the increase in the cost of soy oil. Or,
rather than exercising the option, you might be able to earn an even larger profit by
selling the option to someone else at a higher premium.
This would allow you to profit from any remaining time value as well as the increase in
intrinsic value, both of which would be reflected in the option premium. The ` 450 soy oil
call would be worth at least its intrinsic value of ` 40 which is the difference between the
strike price and the futures price, plus any remaining time value.
In most cases, when an option is in the money and has time value it’s common for someone
to offset, in this case sell back the option, rather than exercising it. That’s because exercising
the option will yield only its intrinsic value. Any time value that remains will be forgone
unless it is offset. Also, an extra brokerage commission may be incurred when exercising
an option.

If the price of soy oil in April declines and is below the option strike price and your call
option becomes out of the money, you can simply let the option expire or sell it back prior
to expiration. In either case, your loss on the option position can be no greater than the
premium paid, and you still will be able to purchase your soy oil at the lower market
price.
Question:
Find out the strategy used by the food processor to hedge soybean oil in foreign exchange.
Source: http://agmarketing.extension.psu.edu/Commodity/PDFs/Future_options_eginners.pdf

6.5 Summary

 The value of an option is determined by its chance to be exercised with profit on the expiry
day. This consists of two parts: the real value and the time value.

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