Question

Ms. Hunter is the chief financial officer for Atlanta Developers. In January, she estimates that the company will need to purchase 300,000 square feet of plywood in June to meet its material needs on one of its office construction jobs.

a. Suppose there is a June plywood contract trading at f0 = $0.20/sq. ft. (contract size is 5,000 square feet). Explain how Ms. Hunter could hedge the company’s June plywood costs with a position in the June plywood contract.

b. Show in a table Ms. Hunter’s net costs at the futures’ expiration date of buying plywood on the spot market at possible spot prices of 0.18/sq. ft., 0.20/sq. ft., 0.22/sq. ft., and 0.24/sq. ft. and closing the futures position. Assume no quality, quantity, and timing risk.

c. Define the three types of hedging risk and give an example of each in the context of this problem.

d. How much cash or risk‐free securities would Ms. Hunter have to deposit to satisfy an initial margin requirement of 5%?

Answer 1

a.

Futures price refers to the price of financial or consumption asset which is computed as taking base of the spot price of such asset as well as taking into account of the other costs. Future price shall be computed by taking interest rate into account for the maturity period given in the case. If the computed future price is not equal to the actual price in the market then there is arbitrage opportunity available in the market.

In the given case, Ms. Hunter will have to purchase 300,000 sq. feet of wood in June thus he will have to go long on wood futures contract at the given rate of $0.20 per sq.feet. After going long on such contracts, Hunter could lock in the price of the contract and she shall pay such price irrespective of whatever price in the market in september.

She will purchase 60 contracts (300,000/5000).

b.

Following is the formula table showing net costs in each of the cases:

Following is the computation of net costs in each of the cases:

Thus the net costs in each of the case has been computed above.

c.

Following are the three types of risk in respect of hedging risk as follows:

-Default Risk: Suppose the person who is going to take delivery of wheat from Mr. Smith, could default in making payment at the specified date.

- Interest Rate risk: Suppose the interest rate in the market could risen up for short term period so that the buyer would not be able to finance the purchase of wheat and could not take up the delivery.

-Quality Risk: In such case, buyer refuses to take delivery as the quality of assets does not match with the specified quality in the contract.

d.

Initial margin is required to be deposited into broker's account as a security deposit which is computed as a percentage of total value of contract.

Initial margin= 5%*(300,000 sq. feet*Futures Rate)

=5%*(300,000 sq. feet*$0.20)

=$3,000

Hence the initial margin has been computed above as $3.000.

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