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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A corporate treasurer is concerned that a commodity price may rise, but wants to keep the benefit if the price falls, and accepts paying an upfront premium. Which instrument is most suitable, and what is the main trade-off compared with a forward?

A long call option is most suitable. It sets a maximum effective purchase price at the strike while allowing the firm to benefit if prices fall. The trade-off versus a forward is the upfront premium, since a forward costs nothing initially but forgoes favorable price moves.

  1. AA long call option; the premium is paid upfront but downside benefit is retainedCorrect
  2. BA short put option; premium is received but downside benefit is lost
  3. CA long forward; no cost but downside benefit is retained
  4. DA short call option; premium is received and upside is protected

Explanation

A long call caps the purchase price at the strike while allowing the firm to buy at the lower market price if prices fall. The cost is the premium. A forward locks the price and removes the favorable move; short options do not protect against price increases adequately.

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