Reference no: EM132371664

1. XYZ mines copper, with fixed costs of $0.50/lb and variable cost of $0.40/lb. Wirco produces wire. It buys copper and manufactures wire. One pound of copper can be used to produce one unit of wire, which sells for the price of copper plus $5. Fixed cost per unit is $3 and non-copper variable cost is $1.50.

Telco installs telecommunications equipment and uses copper wire from Wirco as an input. For planning purposes, Telco assigns a fixed revenue of $6.20 for each unit of wire it uses.

The 1-year forward price of copper is $1/lb. The 1-year continuously compounded interest rate is 6%. One-year option prices for copper are shown in the Table below:

Strike

Call

Put

0.9500

$0.0649

$0.0178

0.9750

0.0500

0.0265

1.0000

0.0376

0.0376

1.0250

0.0274

0.0509

1.0340

0.0243

0.0563

1.0500

0.0194

0.0665

a. Suppose that Wirco does nothing to manage the risk of copper price changes. What is its profit 1 year from now, per pound of copper?

b. Suppose that Wirco buys copper forward at $1. What it is profit 1 year from now?

c. What happens to the variability of Wirco's profit if Wirco undertakes any strategy (buying calls, selling puts) to lock in the price of copper next year?