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Companies buy options to reduce the variability in future cash flows.

Institutional investors invest in portfolios to maximize return for a fixed amount of risk. If an investor owns stock in company A whose cash flows are negatively correlated with the price of commodity B, then he can reduce risk by investing in company A and buying call options in commodity B.

Example 1: Suppose my publicly traded company produces corn. Then my company will very likely buy corn futures to reduce the risk associated with the price of corn falling. My question asks: why don't investors investing in the corn company just buy the corn options themselves? Why are they better off buying the options through the corn company?

Correction for example 2: Apparently there isn't a futures market for lithium. You still get the idea, right?

Example 2: Suppose my publicly traded company produces batteries. Then my company will very likely buy lithium options to reduce the risk associated with the price of lithium rising. My question asks: why don't investors investing in the battery company just buy the lithium options themselves? Why are they better off buying the options through the battery company?

Question: Please prove that, under whatever reasonable assumptions of your choice, it is optimal for the company rather than the investor to trade the options. Under what conditions would it be optimal for the investors rather than the company to buy call options in commodities negatively correlated with the company's profits?

Note: The purpose of this question is to understand the assumptions under which it is optimal for companies (rather than investors) to buy options. That is why I ask for a proof.

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    $\begingroup$ "Companies buy options to reduce the variability in future cash flows". Who said this? $\endgroup$
    – nbbo2
    Commented Jul 12, 2022 at 21:04
  • $\begingroup$ @nbbo2 me. This is my guess of how the world works. This document says farmers buy futures contracts for the commodities they sell. "Farmers may manage the risks from market price fluctuations by using agricultural derivatives, such as futures and options contracts..." I don't know if this would apply to large, publicly traded agriculture companies. I've read that energy companies like Exxon Mobil trade oil futures. I don't know if Apple trades futures. $\endgroup$
    – user62863
    Commented Jul 12, 2022 at 21:16
  • $\begingroup$ E.g. an energy company may also believe to be in a good position to understand the valuation of energy derivatives, e.g. they may hedge more when they see the relevant prices attractive. $\endgroup$
    – fes
    Commented Jul 13, 2022 at 6:28

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You are asking when companies should hedge exposures, and when it’s better left to their stock investors. Here are a few factors that come to mind:

A) transaction costs. It’s generally cheaper for companies to execute derivative hedges than it is for investors.

B) market expectations for the industry. Eg investors may expect that oil companies are intrinsically long oil, and might not appreciate the company to hedge its exposure. On the other hand they might expect airlines to hedge fuel costs.

C) the implied ‘put’. If the hedges go disastrously wrong, the company stock can never go below zero. However hedges done by an investor are not protected in that manner.

D) visibility. The company has a more precise view of the exposures at any moment in time.

Generally speaking, this would indicate that companies are better placed to hedge exposures, although they need to be sure not to hedge away exposures that are actually desired by investors (B above)

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