Question

It is​ April, and Hans Anderson is planting his barley crop near​ Plunkett, Saskatchewan. He is concerned about losing his farm if his operations result in a loss at the end of the season. He expects to harvest 3,000 tonnes of barley and sell it in October. Futures contracts are available for October delivery with a futures price of $200 per tonne. Options with strike price of $200 per tonne are also​ available; puts cost $16 and calls cost $18.

a.Describe how Hans can fully hedge using futures contracts.

b. Given the strategy in a​), what will be the total net amount received by Hans​ (for all 3,000 ​tonnes) if the price of barley in October is as​ follows:i .$150 per​ tonne; ii. $200 per​ tonne; iii. $250 per tonne

c. Describe how Hans can fully hedge using options.

d. Given the strategy in ​(c​), what will be the total net amount received by Hans​ (for all​ 3,000 tonnes) if the price of barley in October is as​ follows:i. $150 per​ tonne; ii. $200 per​ tonne; iii. $250 per tonne

e. Hans has asked for your advice regarding hedging. Discuss how the each of the following individually will influence your advice.

i. Hans does not expect to have much cash available between May and September.

ii. Hans thinks there is a 25​% chance his crop will be destroyed by hail before he has a chance to harvest it.

iii.​ Hans's farming business will go bankrupt if his net revenues in October do not cover his costs. He estimates his costs will be $600,000. If his business goes​ bankrupt, Hans's bank will foreclose and take his house and farm.

iv.​ Hans's farming business will go bankrupt if his net revenues in October do not cover his costs. He estimates his costs will be $800,000. If his business goes​ bankrupt, Hans's bank will foreclose and take his house and farm.

Answer 1

a. Hans will lose money if the price of barley in october is lower than expected. Thus, he has to sell future contracts of barley to hedge against the risk of prices being lower than $200 per tonne. Hans can fully hedge using futures contract by selling 3,000 october futures with delivery at $200 per tonne.

b. i. If the price of barley in october is $150 per tonne. Hans will sell 3,000 tonnes of barley in spot market at $ 150 per tonne. For offsetting the futures trade he will have to buy futures at $150 per tonne in october which he sold at $ 200 per tonne. Thus, there will be a profit in futures contract of $50 per tonne.

Barley sales = 3,000 tonnes * $ 150 per tonne = $450,000

Profit in futuures = 3,000 tonnes * $ 50 per tonne = $150,000

Total Proceeds = $600,000.

b. ii. If the price of barley in october is $200 per tonne. Hans will sell 3,000 tonnes of barley in spot market at $ 200 per tonne. For offsetting the futures trade he will have to buy futures at $200 per tonne in october which he sold at $ 200 per tonne. Thus, there will be no profit and no loss in futures contract.

Barley sales = 3,000 tonnes * $ 200 per tonne = $600,000

Profit in futuures = 3,000 tonnes * $ 0 per tonne = $0

Total Proceeds = $600,000.

b.iii. If the price of barley in october is $250 per tonne. Hans will sell 3,000 tonnes of barley in spot market at $ 250 per tonne. For offsetting the futures trade he will have to buy futures at $250 per tonne in october which he sold at $ 200 per tonne. Thus, there will be a loss in futures contract of $50 per tonne.

Barley sales = 3,000 tonnes * $ 250 per tonne = $750,000

Loss in futuures = 3,000 tonnes * $ 50 per tonne = $150,000

Total Proceeds = $600,000.

Thus, whatever be the price of barley in october, Hans will receive $600,000 as he hedged with futures contract.

c. Hans will want a right to sell barley at $ 200 per tonne. Thus, he will buy 3,000 put options of $ 16 with a strike price of $200 per tonne.

d.i. If the price of barley in october is $150 per tonne. Hans will sell 3,000 tonnes of barley in spot market at $ 150 per tonne. As the market price (150) is lower than strike price(200), Hans will exercise the put option. Thus, there will be a profit in options contract of $ 34 (50-16) per tonne.

Barley sales = 3,000 tonnes * $ 150 per tonne = $450,000

Profit in put option = 3,000 tonnes * $ 34 per tonne = $102,000

Total Proceeds = $552,000.

d.ii. If the price of barley in october is $200 per tonne. Hans will sell 3,000 tonnes of barley in spot market at $ 200 per tonne. As the market price (200) is same as strike price(200), Hans will not exercise the put option.

Barley sales = 3,000 tonnes * $ 200 per tonne = $600,000

Cost of put options = 3,000 tonnes * $ 16 per tonne = $48,000

Total Proceeds = $552,000.

d.iii. If the price of barley in october is $250 per tonne. Hans will sell 3,000 tonnes of barley in spot market at $ 250 per tonne. As the market price (250) is higher than strike price(200), Hans will not exercise the put option.

Barley sales = 3,000 tonnes * $ 250 per tonne = $750,000

Cost of put options = 3,000 tonnes * $ 16 per tonne = $48,000

Total Proceeds = $702,000.

Thus, Hans will get $ 552,000 if the price in october is lower than or equal to $200 per tonne and he will get more money if the price is above $200 per tonne.

e.i. If Hans does not have much cash available between May and september, he should

prefer options instead of futures contract as they cost less amount as compared to futures margin.

e.ii. If Hans thinks there is a 25% chance that hail will destory his crop till harvest, he should opt for non- delivery contract i.e, cash settled contract instead of delivery contract to hedge.

e.iii. If cost is $600,000 and Hans will go bankrupt if net revenues in october do not cover the costs, he can opt for futures if he thinks there is a probability of price in october being lower than $200 per tonne. This is because in futures, whatever may be the price in october, he will get net revenue of $600,000 in october.

e.iv. Hans can profit in options contract more if price in october is more than strike price, whereas in futures contract he will get only $600,000 no matter whatever the price is in october. If cost is $800,000 and Hans will go bankrupt if net revenues in october do not cover the costs, he should opt for options contract.