Two-State Option Pricing Model Maverick Manufacturing, Inc., must purchase gold in three months for use in its operations. Maverick’s management has estimated that if the price of gold were to rise above $375 per ounce, the fi rm would go bankrupt. The current price of gold is $350 per ounce. The fi rm’s chief fi nancial offi cer believes that the price of gold will either rise to $400 per ounce or fall to $325 per ounce over the next three months. Management wishes to eliminate any risk of the fi rm going bankrupt. Maverick can borrow and lend at the risk-free EAR of 16.99 percent.

a. Should the company buy a call option or a put option on gold? To avoid bankruptcy, what strike price and time to expiration would the company like this option to have?

b. How much should such an option sell for in the open market?

c. If no options currently trade on gold, is there a way for the company to create a synthetic option with identical payoffs to the option just described? If there is, how would the fi rm do it?

d. How much does the synthetic option cost? Is this greater than, less than, or equal to what the actual option costs? Does this make sense? LO.1