Question

Suppose that the manager did place the hedge in May. We are now on October 15th, 2020 and the plant has just taken delivery of the corn whose price she hedged. She is now managing price risk for the next corn intake, for mid-February, and is considering using a futures hedge to lock in a price. Which maturity should she use?

a. December 2020 (expires Dec. 15)

b. March 2021 (expires Mar. 15, 2021)

c. May 2021 (expires May, 2021)

d. Not enough information

Answer 1

Since the manager wants to hedge the price risk for mid february of corn prices, it should use the nearest possible month futures contract as the basis risk i.e. the risk of differnce in spot and future price would be lower. The explanations for all the options would be as follows:

a. Dec 2020: It shouldn't be followed as this future contract would expiry in december only. And the firm would still be exposed for 2 months of price movements. If prices of corn between December and February rise much, futures won't be able to control the price risk and we would loose much.

b. Mar 2021: This is the best among available option if there are no futures contract are there for February. This is because the price for February corn would be dependent upon:

Effective Price of Corn = Future Price of March + Basis Risk (Spot Price on Feb - Future Price)

Since future price is fixed as we enter into the contract and we are only exposed to basis risk. As the gap would change, our position can be in risk. That's why, we should use near month contract to hedge risk appopriately as other future contracts might have high basis risk.

c. May 2021: Since this expiry is 3 months away from Mid February, this might have high basis risk. Thus, it is not good option.

d. Not enough Information: This should not be used as is has most of the information to solve this problem.

Thus, option (b) i.e. Mar 2021 futures should be used.