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%?

Solutions

Expert Solution

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.

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.

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.

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 3 months ago

Next > < Previous

Related Solutions

Explain how the clearinghouse would record the following: Mr. A buys a September wheat futures contract...

Explain how the clearinghouse would record the following: Mr. A buys a September wheat futures contract from Ms. B for $4 .00/bu. on July 20. Mr. D buys a September wheat futures contract from Mr. E for $3 .95 on July 25. Ms. B buys a September wheat futures contract from Mr. D for $4 .01 on July 30. Mr. E buys a September wheat futures contract from Mr. A for $4.06 on August 3. Show the clearinghouse’s payments and...

Mr. Smith is the CFO of Suffolk Fasteners, Inc. and he is preparing for a meeting...

Mr. Smith is the CFO of Suffolk Fasteners, Inc. and he is preparing for a meeting with SCC Bank to arrange the financing for the first quarter of 2020. Based on his sales forecast and the information he has provided (as detailed in the Situation below), your job as the company’s new management accountant is to prepare the following budgeted reports for the First Quarter of 2020: Monthly Sales Budget Monthly Production Budget Monthly Direct Materials Budget Situation: Suffolk Fasteners,...

Mr Smith is on another tirade against honeydew. He found another fruit bowl which had 18...

Mr Smith is on another tirade against honeydew. He found another fruit bowl which had 18 out of 45 honeydew. He once again believes this is an affront to his rule which says honeydew must be at 30%. This had more! Does he have a right to believe the store is increasing the amount . The standard error for his study will be .0683. a) (4 points) Create the Hypothesis Test for this scenario. b) (2 points) Find the test statistic...

You review EPIC for Mr. Smith and find that he was admitted to the hospital last...

You review EPIC for Mr. Smith and find that he was admitted to the hospital last night with the diagnosis of bleeding esophageal varices. He is 38 years old, 6’ tall, and weighs 155 lbs. He has a history of alcohol abuse and bipolar disorder. He is on bedrest with bathroom privileges, NPO, and has an IV with lactated ringers running at 125mL/hr. He is a bit confused and has been shivering. His temp is 100.6° F. He is scheduled...

Mr. Smith is a resident of the UK. Last year he sold an apartment in Germany....

Mr. Smith is a resident of the UK. Last year he sold an apartment in Germany. According to the DTC between UK and Germany income derived from immovable property is taxable in the Contracting State in which the property is situated (Article 6). Besides this, Article 13(1) of the same DTC provides that gains arising on the disposal of immovable property are taxable in the Contracting State in which the property is situated. Finally, Article 23 of the tax treaty...

Steve Smith sold for $380,000.00 in September of 2019 his residence that he had purchased in...

Steve Smith sold for $380,000.00 in September of 2019 his residence that he had purchased in 2015 for $175,000.00. He made capital improvements during his 4-year ownership totaling $20,000.00. He paid selling expenses of $10,000.00. What is his recognized gain should he elect to use Section 121? Suppose instead that Steve sold his home in November 2019 for $ 520,000.00. What is his recognized gain should she elect §121 treatment? How long does he have...

Mr. Mark Smith loved gardening. He had several expensive tools that he kept in his yard....

Mr. Mark Smith loved gardening. He had several expensive tools that he kept in his yard. He lived in a good neighborhood and did not worry about his expensive tools stored outside. One weekend, he found a couple of tools missing; puzzled he asked his family if they had moved the tools. Everyone told him that they had not touched the tools. Next weekend, he noticed that another tool was gone. At that point, he was frustrated and wanted to...

Mr. Smith has a duodenal ulcer and a new prescription for sucralfate. He asks the nurse...

Mr. Smith has a duodenal ulcer and a new prescription for sucralfate. He asks the nurse how this medication works, and you correctly respond that it: A. Prevents gastric acid secretion in the stomach B. Neutralizes gastric acid after it is secreted C. Adheres to the ulcer and protects it from gastric acid D. Kills the bacteria which cause ulcers

A farmer pays $0.20 for seed that he uses to grow wheat which he sells to...

A farmer pays $0.20 for seed that he uses to grow wheat which he sells to the miller for $0.40; the miller makes wheat flour and sells it to the baker for $0.60. The baker makes bread and sells it to the grocery store for $0.80 and the store sells it to the consumer for $1.00. The total contribution to the Gross Domestic Product (GDP) from all these transactions is A. $3.00 B. $2.00 C. $1.00 D. $0.20 2- ...

Mr X has 50,000 dollar in a bond fund and expects that every year he will...

Mr X has 50,000 dollar in a bond fund and expects that every year he will be able to save and add 12,000 dollars to the bond fund. Assuming that the bond fund will give 7% return per year, how much money will he have by the time of retirement (12 years).

Subjects