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IAI Actuarial Core Principles · Business Finance · Financial instruments issued or used by companies

A manufacturer buys a call option on copper to protect against rising input prices. Compared with buying copper futures for the same quantity and date, which statement is correct?

The option costs a premium upfront but lets the firm gain if copper prices fall, because it can let the option lapse and buy at the lower market price. Futures lock in the price and remove that benefit, and the option's maximum loss is just the premium.

  1. AThe option costs a premium upfront but lets the firm benefit if copper prices fallCorrect
  2. BThe option has no upfront cost but obliges the firm to buy at the strike
  3. CThe futures contract lets the firm benefit if prices fall below the futures price
  4. DThe option's maximum loss is unlimited if prices fall
  5. The option and the futures give identical payoffs at expiry

Explanation

A purchased call costs a premium, and its loss is limited to that premium. If copper falls, the firm lets the option lapse and buys at the lower market price. Futures fix the price and give no benefit from a fall, so the payoffs differ.

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