The profit margin of WeDig:  23.63%

the copper price at which WeDig achieves exactly its target rate: 9146.34

the critical copper price for WeDig: 8620.69

the forward price for a contract expiring on 1 Nov 2022: 9893.93

 

1. WeDig considers the following five hedging strategies for managing commodity price risk:

Strategy I: No hedge at all.

Strategy II: Hedging 100% of the mining output with a forward contract.

Strategy III: Hedging 40% of the mining output with a forward contract and leaving the remaining 60% unhedged.

Strategy IV: A strategy using one of the options given above to meet the target rate and benefit from favourable movements in the copper price.

Strategy V: A strategy using one of the options given above for worst-case protection only (meet critical rate).

For each of these strategies:

Calculate the profit margin for the following two scenarios:

 

a) The copper spot price on 1 Nov 2022 is $10,500 per ton.

b) The copper spot price on 1 Nov 2022 is $8,300 per ton.

 

2. Explain the advantages and disadvantages of each hedging strategy.

3. If a strategy includes options, state clearly which option contract should be used, whether as a long or short position, and why.

4. As an alternative hedging strategy, WeDig is also considering using copper futures contracts traded on the London Metal Exchange, which is a world leading derivatives marketplace for industrial metals. Without any calculations, discuss advantages and disadvantages of a hedging strategy using LME futures as compared to using forward contracts with the WeTradeDerivatives bank.

Assume today is May 1, 2022. Company WeDig is a copper mining company producing copper with plans to increase its size and valuation over the next few years. The company has invested in developing copper mines and commenced extracting copper and copper production from its underground mines. The company is confident that it will have an output of 50,000 tons of copper on 1 November 2022 and is willing to sell this output amount on that day. The company's revenue is subject to changes of the copper price. As the market price of copper is quite volatile, the company is considering using some strategies to manage its risk exposure. Following further information is available: Profit margin is defined as (Revenue - Cost of Goods Sold) / Revenue. The cost of mining one ton of copper is $7,500. The company has a target profit margin of 18%. The minimum acceptable profit margin below which the company will have difficulties servicing its debt is 13%. The spot price of copper on 1 May 2022 is $9,820. The interest rate curve is flat and the risk-free interest rate for all maturities is 1.5% (cont. comp.). The company regularly transacts with the WeTradeDerivatives Bank which is available as a counterparty of forward and option contracts with copper as an underlying asset. Following option contracts expiring on 1 Nov 2022 are available: Option Type Strike price Option Premium Put option Call Option Put option Call Option $8,900 $8,900 $9,750 $9,750 $172.93 $1,159.43 $481.06 $623.91 Based on this information and the knowledge you have obtained while taking this Derivatives course, respond to the questions below.