Question One

a) Suppose you are the chief financial officer of Hotels International and you purchase 35,000 pounds of coffee each month. You are concerned about the price of coffee three months from now. The spot price is now $1.45/pound but it is likely to go up. To protect yourself against the risk, you decide to use futures contracts. The futures contracts are for 35,000 pounds of coffee, have a current price of $1.50/pound and expire in three months. Show the cash flows of the futures contracts, of the underlying transaction and of the hedge strategy if the spot price of coffee on the delivery date is $1.25/pound, $1.50/pound or $1.75/pound.

(10 marks)

b) There are a call and a put option contract available for 35,000 pounds of coffee with an expiration date in three months. The strike price is $1.50 and the premium for the put is $52.50 for 1000 pounds of coffee and the premium for the call is $62.00 for 1000 pounds of coffee. Show the cash flows of the option contracts, of the underlying transaction and of the hedge strategy if the spot price of coffee on the delivery date is $1.25, $1.50 or $1.75. Explain how you can hedge your position (with the call or the put option) against the rise in the price of coffee.

(10 marks)

c) Assume that the market price in three months was $1.25. Your friend suggests that you should have hedged your position with a futures and not an option contract. Is she right? Why?

(5 marks)