Query Corner: Commodity Query

Assuming a transformer manufacturer needs copper as raw material in his factory, I would like to know how the manufacturer can benefit from ‘copper options’ to hedge the raw material cost risk.

Also, how will a copper miner manage the price risk using “copper options?” How does settlement take place in the commodity option contract? Further, does the copper miner need to deliver the commodity to the transformer manufacturer at a pre-determined price on expiry of the contract?

Nilanjan Chakrabarti, Salt Lake, Kolkata

Last week’s column explained in detail the working of commodity options. Please do refer to it for answers to your query.

A transformer manufacturer who uses copper as an input should buy a call option. Say, he buys a call option for 5 tonnes of copper at ₹350/kg, three months from now, and prices reach ₹400 by the time the options contract expires; he will get the profit of ₹50/kg in his account.

If the underlying is a futures contract, he will then get a position in the futures contract too. Here, it will be a ‘buy’ position at ₹400/kg. He can then decide to close the futures position immediately, or keep it open till expiry and deliver the commodity.

On the other hand, if price falls and goes below ₹350/kg, the option contract will expire automatically, and loss will be limited to the premium paid on the contract.

A copper miner will have to buy a put option in copper if he wants to hedge the price risk. At the time of expiry of the contract, if the price has fallen, he will get the profit in his trading account and get a ‘sell’ position in the futures market too.

He can square-up the futures contract immediately or keep it open till the staggered delivery period and deliver the copper to exchange’s warehouse.

But, do note, by keeping the futures position open, the individual exposes himself to price volatility in the futures market. And, the copper’s specification should be as per the terms of the futures contract.

It is suggested that commodity users look at ‘options’ as a risk management tool rather than using it as a platform for business.

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