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 comma 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 $ 20. 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 comma 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 $ 570 comma 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 comma 000. If his business goes​ bankrupt, Hans's bank will foreclose and take his house and farm.

Answer 1

Plan:

Hans, as a producer of barley, is concerned that when he sells it, the price may have dropped. He can consider various hedging strategies but must also consider the cost of hedging and his production costs.

Excecute:

a.

Hans can take a short position in futures on 3000 tonnes of barley for delivery in October.

b.

i. 3000 tonnes × $200/tonne = $600,000

ii. 3000 tonnes × $200/tonne =$600,000

iii. 3000 tonnes × $200/tonne =$600,000

c.

Hans can purchase the put options on 3000 tonnes of barley

d.

i. He already paid for the put options an amount of $16/tonne × 3000 tonnes = $48,000. With the market price of barley below the put’s strike price, he will exercise the put to receive $200/tonne × 3000 tonnes = $600,000. His total net amount received is thus $600,000 - $48,000 = $552,000

ii. He already paid for the put options an amount of $16/tonne × 3000 tonnes = $48,000. With the market price of barley equal the put’s strike price, he can let the puts expire and sell at the market price or he can exercise the puts and sell at the strike price (it doesn’t matter, both give the same result) to receive $200/tonne × 3000 tonnes = $600,000. His total net amount received is thus $600,000 - $48,000 = $552,000

iii. He already paid for the put options an amount of $16/tonne × 3000 tonnes = $48,000. With the market price of barley above the put’s strike price, he will let the puts expire and sell the barley at the market price of $250 per tonne to receive $250/tonne × 3000 tonnes = $750,000. His total net amount received is thus $750,000 - $48,000 = $702,000

e.

i.  

Since the futures contracts would be market to market each day and Hans may have a margin call if his account balance falls to low, if he won’t have funds available, then he should avoid the potential liquidity problem that might arise from using the futures hedge.

ii.

Given the possibility he will not have a crop to sell, the options hedge may be preferable as with the options contracts he is not obliged to sell the barley but with the futures contract he is obliged and the futures may result in a large loss if he is forced to offset his position at a higher futures price.

iii.

With the futures hedge, Hans will be guaranteed to receive $600,000 (as long as his crop can be sold) so he will cover his costs with certainty and will not bear any financial distress costs. With the options hedge, if barley prices are below $206 (570000 + 48000 / 3000) /tonne he will receive less than $570,000 in net revenues (when barley is below $200/tonne he will only receive net revenues of $552,000) so he will have a shortfall, go bankrupt, and bear significant personal financial distress costs. Thus, in this case, the futures hedge is preferred.

iv.  

With the futures hedge, Hans will lock in a certain loss, go bankrupt, and bear the financial distress costs with certainty. His revenues minus costs will be $600,000-$800,000 = -$200,000 with certainty. Thus he should not use the futures hedge. With the options hedge, Hans will have a loss for any barley price below $282.67 ( 800000 + 48000 / 3000 ) /tonne but he will be solvent if barley prices are higher than that. The options hedge is better than the futures hedge as it gives him a chance of solvency whereas the futures give him certain failure. However, the best strategy for Hans in this situation is to not hedge at all. With costs of $800,000 he will break even with a barley price of $800,000/3000 tonnes = $266.67/tonne. Note, without hedging, the barley price can be $16 less than required with the put options hedge ($16 is the cost of the put option), so there is more possibility that the final barley price will allow Hans to remain solvent. Your advice in this scenario is not to hedge.

Evaluate:

Depending on the circumstances, the options hedge may be better or the futures hedge may be better or not hedging at all may be better. It is important to consider all factors and outcomes before deciding what if any hedging strategy should be used.