Maverick Manufacturing, Inc., must purchase gold in three months for use in its operations. Maverick’s management has estimated that if the price of gold were to rise above $1,610 per ounce, the firm would go bankrupt. The current price of gold is $1,530 per ounce. The firm’s chief financial officer believes that the price of gold will either rise to $1,765 per ounce or fall to $1,420 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 EAR of 7.5 percent.
a. Should the company buy a call option or a put option on gold?
a2. What strike price would the company like this option to have?
b. How much should such an option sell for in the open market?
c. Suppose no options currently trade on gold. What are the transactions needed to create a synthetic option with identical payoffs to a traded option?
d. How much does the synthetic option cost?