Question

The following questions use the table below about a farmer looking to sell soybeans later this year.

	Now	Later
Cash Soybeans Market	$7.83/bu	$8.58/bu
Futures Soybeans Market	$7.58/bu	$8.33/bu

1) Is the individual concerned about price increasing or decreasing?

2) What is the initial action in the futures market: buy or sell?

3) What is the cash price paid/received by the individual later?

4) Did the individual earn a profit or loss in this hedging situation? Enter profit or loss in the following blank.

5) What is the value (i.e. amount) of the profit/loss on the hedge for one contract (signs matter)?

6) The farmer expects to hedge 3 contracts with each contract representing 5,000 bushels. What is the total (dollar) value of the profit/loss on this hedge?  

7) What is the hedged price per bushel on this transaction?

8) If the individual didn't hedge, what would have been the price paid/received for cash soybeans?

9) The individual made the right decision to hedge: Yes or No.

Answer 1

1. The farmer would like to sell later the year. The objective will be to have a higher selling price to gain more profits and he would like to avoid selling price being lower as his gains will also be lower or he might make a loss. Thus, the individual is concerned about price decreasing.

2. The initial action in the futures market will be to sell the futures.

3. The individual will sell at cash price later. Cash price later is $8.58 per bu. Thus, the individual will receive $8.58 later as cash price.

4. The following is the hedging strategy

Step 1: Sells future contract now at $7.58 per bu

Step 2: Sell the soyabeans at cash later for $8.58 per bu

Step 3: To honour the futures, buy the futures later at $8.33 per bu

Thus, net receipt (net hedging price)= Cash received on sale - (Value of futures bought - value of futures sold) = $8.58 - ($8.33-$7.58) = $7.83 which is actually the cash price now.

Thus, in the hedging strategy, because the farmer was concerned that the price will decrease, the farmer made the above hedging strategy so as to lock the cash sale price now of $7.83 as this will protect the farmer if the price decreases.

However, since the cash price actually increased to $8.58 per bu, the farmer has made a loss by entering into the hedging strategy since the net receipt would have been $8.58 per bu had there was no hedging. But instead the net receipt is now only $7.83.

5. The loss = Cash price later - Net hedging price = $8.58 - $7.83 = $0.75 per bu

One contract has 5,000 bushels. Thus, loss for one contract = 5,000*$0.75 = $3,750 (loss) per contract.

6. If the farmer has hedged with 3 contracts with 5,000 bushels each, the total value of the loss = Number of contracts * bushel per contract * loss per bushel = 3*5,000*$0.75 = $11,250 (loss)

7. Hedged price per bushel = Cash received on sale - (Value of futures bought - value of futures sold) = $8.58 - ($8.33-$7.58) = $7.83 per bushel

8. If the individual didnt hedge, the price received will be $8.58 per bushel.

9. The individual made the right decision to hedge - No (since he made a loss by hedging).