3. Suppose you are advising a widget firm on risk management strategy. It has a factory capable of producing ten widgets per year. Each widget requires one unit of a perishable commodity, berzel, which cant be stored and must be used immediately after purchase. This year, the firm plans to produce 10 widgets. The berzel will be needed as a finishing touch for the widgets at the end of the year. The firm has a supply contract to provide 10 widgets at the end of the year in exchange for a payment of $20,000 now. The firm thus has $20,000 cash and no access to other sources of external financing. If the firm fails to fulfill its contract, it loses its factory and future rights to produce. The lending rate is zero percent.

a) What objective would you target for this firm when formulating a risk management strategy? In other words, what outcome are you trying to achieve or avoid?

b) Consider the derivatives discussed in class: 1) forwards, 2) calls, and 3) puts. Assume the underlying in each case is berzel. For each derivative, identify the direction of the position (e.g., long or short) that you would take to manage risk in this situation (assuming that the firm is in fact able to buy the derivative, if a premium is necessary).

c) Suppose the only derivative available is a one year put on berzel on with strike price 1800. It is priced at $200 per unit. Could you use this derivative to help you accomplish your goal in a)? How? Also, describe the circumstances, if any, under which your strategy would accomplish your goal, and those, if any, under which it would fail.

d) Suppose now that, in addition to the put described in c), there is also a one year call option on berzel with strike price 2100 that is priced at $100 per unit. Is there a risk management strategy for the firm that will fully protect against bankruptcy? Describe it.