Question

In: Finance

In May, Mr. Smith planted a wheat crop, which he expects to harvest in September. He...

In May, Mr. Smith planted a wheat crop, which he expects to harvest in September. He anticipates the September harvest to be 10,000 bushels and would like to hedge the price he can get for his wheat by taking a position in a September wheat futures contract.

a. Explain how Mr. Smith could lock in the price he sells his wheat with a September wheat futures contract trading in May at f0 = $4.50/bu. (contract size of 5,000 bushels).

b. Show in a table Mr. Smith’s revenue at the futures’ expiration date from closing the futures position and selling 10,000 bushels of wheat on the spot market at possible spot prices of $4.00/bu., $4.50/bu., and $5.00/bu. Assume no quality, quantity, or timing risk.

c. Give examples of the three types of hedging risk in the context of problem b.

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

Expert Solution

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, Mr. Smith will have 10,000 bushels of wheat in september thus he will have to go short on wheat futures contract at the given rate of $4.50 per bushel. After going short on such contracts, Mr Smith could lock in the price of the contract and he shall be paid such price irrespective of whatever price in the market in september.

b.

Following is the formula table showing revenue in each of the cases:

Following is the computation of revenue in each of the cases:

Thus the revenue 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%*(10,000 Bushels*Futures Rate)

=5%*(10,000 Bushels*$4.50)

=$2,250

Hence the initial margin has been computed above as $2.250.

If you still have any doubt, then please ping me in the comment box, I would love to help you.

jeff jeffy answered 9 months ago

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