Objectives When Formulating a Risk Management Strategy

Question

Suppose you are advising a gold mining firm on risk management strategy.  It has a mine capable of producing ten ounces of gold per year.  This year, the firm plans to produce 10 ounces.  The firm’s cost of production in $1200 per ounce, which it is committed to paying at the end of the year.  The firm has $1000 cash and no access to other sources of external financing.  If it fails to meet its production target, it loses its factory and future rights to produce.  The lending rate is zero percent.

• 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?

• Consider the derivatives discussed in class: 1) forwards, 2) calls, and 3) puts. Assume the underlying in each case is gold.  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).

• Suppose the only derivative available is a one year call on gold with strike price 1500. It is priced at $100 per ounce.  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.

• Suppose now that, in addition to the call described in c), there is also a one year put option on gold with strike price 1100 that is priced at $100. Is there a risk management strategy for the firm that will fully protect against bankruptcy?  Describe it.