BUS 551 Module 7 Options and Risk Management Example

Locking the Cost of Metal, Not the Bet on It: An Aluminum Hedging Program for a Fishing Boat Maker

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MBA Program, Aspen University

BUS 551: Corporate Financial Management

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Month Day, Year

Locking the Cost of Metal, Not the Bet on It: An Aluminum Hedging Program for a Fishing Boat Maker

Lake Country Marine, a composite company in northern Wisconsin, builds welded and riveted aluminum fishing boats sold through about 220 dealers in the Midwest and Canada. It buys about 4,000 tons of aluminum sheet a year, roughly a third of the cost of each boat. Each summer, it sets dealer prices for the following model year, but it buys most of its aluminum during the fall and winter, when boats are built. Last year, aluminum prices rose sharply after dealer prices were set, and the company's operating earnings fell by more than a third. Its board has asked whether and how to hedge.

Measuring the Exposure

At $2,600 a ton, Lake Country's annual aluminum cost is about $10.4 million. Its operating earnings in a normal year are about $5.5 million. A 25% rise in aluminum, to $3,250 a ton, would raise costs by $2.6 million and cut operating earnings by nearly half, because dealer prices cannot be changed until the next model year. A 15% fall would raise earnings by about $1.6 million. The exposure is large relative to earnings and one-sided in timing: prices are fixed before costs are known.

Why Hedge at All

Finance theory warns that hedging is not automatically valuable, since shareholders can diversify commodity risk in their own portfolios. Froot et al. (1994) argued that the case for corporate hedging rests on investment: when a firm's internal cash falls, it may have to cut valuable investments because outside financing is costly or unavailable, especially for smaller firms. Risk management adds value when it ensures that the firm has the cash to make good investments in bad times. Lake Country plans a new welding line and a dealer financing program over the next two years, both funded from operating cash. A sharp aluminum spike would force it to delay both. Hedging protects that investment plan.

The Instruments

Futures contracts on aluminum, traded on commodity exchanges, let the company lock in a price for future purchases. If prices rise, gains on the futures offset higher costs; if prices fall, losses on the futures offset savings. A futures hedge removes both the risk and the opportunity.

A call option lets its holder buy at a fixed strike price if that turns out to be worthwhile, and walk away if not. For a premium, they cap the cost while preserving the benefit of falling prices. Black and Scholes (1973) showed that an option's value depends on the current price, the strike price, the time to expiration, interest rates and, crucially, the volatility of the underlying price. Because aluminum prices have been volatile, call options are expensive: a broker quotes a premium of about $120 a ton for a strike of $2,900.

A collar combines buying a call and selling a put. Lake Country could buy calls at $2,900 and sell puts at $2,400, so that its effective price stays between $2,400 and $2,900. The premium received from selling puts roughly offsets the premium paid for calls, making the collar nearly costless, but the company gives up savings if prices fall below $2,400.

Comparing Outcomes

The table shows the effective annual cost of aluminum for the full 4,000 tons under each approach, at three possible prices. Option premiums are included.

Futures produce the same cost regardless of price. Calls protect against the spike but cost $480,000 in premiums every year. The collar caps the cost at $11.6 million without a premium and keeps part of the benefit of moderate price declines.

Basis Risk and Accounting

Two practical issues affect the program. Lake Country buys rolled sheet, whose price includes a fabrication premium above the exchange price of primary aluminum; hedges on the exchange price protect against moves in primary aluminum but not against changes in that premium. This basis risk is one reason to negotiate index-linked pricing with the supplier. Second, hedges must be accounted for carefully; hedge accounting rules allow gains and losses on qualifying hedges to be matched with the purchases they protect, but only if the program is documented in advance and its effectiveness is assessed. The controller should set up that documentation before the first trade.

How Much to Hedge

Guay and Kothari (2003), studying the derivative holdings of large nonfinancial firms, found that most firms' derivative positions were small relative to their overall exposures and to firm value, suggesting that companies typically hedge part of their risk rather than all of it. Partial hedging also suits Lake Country, because its volumes depend on boat sales: if sales fall, the company will buy less aluminum, and hedging 100% of expected purchases could leave it holding hedges larger than its needs.

Recommendation

Lake Country should adopt a written hedging policy approved by the board. It should hedge about 60% of the next twelve months' expected aluminum purchases with collars, setting the ceiling near the price used in dealer pricing, and leave the rest unhedged. Only the chief financial officer and controller may place hedges, positions may never exceed 80% of expected purchases, and the board's audit committee will receive a monthly report of positions and their value. The company should also negotiate with its aluminum supplier for pricing linked to an index plus a fixed fabrication charge, so that its hedges track its actual cost closely.

Conclusion

Lake Country's exposure to aluminum is large, and its timing, with prices fixed before metal is bought, makes it dangerous to the company's investment plans. Theory supports hedging when it protects the cash needed for investment, option pricing explains why calls are costly, and evidence suggests partial hedges are typical. A collar on 60% of expected needs, governed by clear rules, caps the damage of a price spike at little cost while keeping some benefit if prices fall.

References

Black, F., & Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81(3), 637-654. https://doi.org/10.1086/260062

Froot, K. A., Scharfstein, D. S., & Stein, J. C. (1994). A framework for risk management. Harvard Business Review, 72(6), 91-102.

Guay, W., & Kothari, S. P. (2003). How much do firms hedge with derivatives? Journal of Financial Economics, 70(3), 423-461. https://doi.org/10.1016/S0304-405X(03)00179-X