Question

Consider a firm, Firm A, who needs to purchase bushels of corn in December of 2018. The current price per bushel of corn is $3.60. Assume the firm cannot pass on any increased costs due to changes in price to their customers.

(a) What type(s) of derivative contract(s) could Firm A use to hedge its price risk for all future prices of corn? What position should Firm A take (buy/long or sell/short)?

(b) What type(s) of derivative contract(s) could Firm A use to hedge its price risk for a specific range of prices? Be specific. What position should Firm A take (buy/long or sell/short)?

(c) Describe some advantages and disadvantages of each in part (a) and (b).

A single futures contract for corn is for 5,000 bushels, but prices are quoted per bushel. For example, the total payment at maturity for one May 2018 contract would be $18,400 (5,000 bushels x $3.68 per bushel). Contracts are available that expire in March (14 Mar 2018), May (14 May 2018), July (13 Jul 2018), September (14 Sept 2018) and December (14 Dec 2018) of this year.

Maturity Date	Futures Price
MAY 2018	$3.68
JUL 2018	$3.76
SEP 2018	$3.83
DEC 2018	$3.92
MAR 2019	$4.00

(d) Suppose Firm A needs to purchase 11,000 bushels on December 1, 2018. Can Firm A completely hedge its price risk with futures contracts? Explain why or why not.

Answer 1

a) Here, the Firm A can use Forward/future contracts to hedge its price risk. These both can be used as the firm wants to hedge for all the prices. here, the firm is not the producer so it has the buy/long of the contract.

b) For a specific price range, its better to buy Dec 2018 futures contract as it would provide Hedging to all the previous price ranges. Options can also be a good choice as it provides, right but not the obligation to buy the commodity at that price.

c)

Future contracts	Options
Advantages
Low margins	Help in creating unique strategies
Traded on exchange so reduce counter party risk	Low capital requirements
Cost to trade is low
Disadvantages
Not very flexible in trading	They have low liquidity
primarily a speculative product	Highly dependent on time value of money

d) no through Futures contract, the firm cant completely hedge its price risk as the contract size is 5000 while the firm needs to purchase 11,000 bushels. They can buy two contracts but for 1000 bushels they cant use Future contracts.