Maverick Manufacturing, Inc must purchase gold in three months to use in its operations. Maverick's management has estimated that if the price of gold were to rise above $375 per ounce, the firm would go bankrupt. The current price of gold is $350 per ounce. The firm's chief financial officer believes that the price of gold will either rise to $400 per ounce or fall to $325 per ounce over the next three months. Management wishes to eliminate any risk of the firm going bankrupt. Maverick can borrow and lend at the risk-free interest rate of 16.99 percent per annum (effective annual yield).
a. Would Maverick be interested in buying a call option or a put option on the price of the gold? In order to avoid bankruptcy, what strike price and time to expiration would the firm like this option to have?
b. How much should such an option sell for in the open market?
c. If no options currently trade on gold, is there a way for Maverick to create synthetic option with identical payoff to the option described above? If there is, how would the firm do it?
d. How much does the synthetic option cost? Is this greater than, less than, or equal to what the actual option costs?
The solution explains in the use of options for buying gold