Question

The CME is the world's largest futures trading center for non storable commodities, one of which is live cattle futures. In November, a cattle 12 producer buys feeder cattle with the intent to feed them for future sale in April. To cover all production costs and guarantee a profit, the producer will need to sell the cattle at $65/cwt. The current April live cattle futures price is $70/cwt. and the basis is $3.00.

a) Set up a short hedge position for this cattle producer and analyze it assuming that the futures price at the beginning of April, when the contract is bought
back is at $65 and the basis has narrowed by $1.0.
b) Repeat (a) and compute the realized price in April if the futures price in April is $72 and the basis has remained unchanged.

Answer 1

a) Short hedge position : It implies that catle producer will sell the April futures at $70/Cwt in order to book the sell price.Further, in order to hedge the position, cattle producer will buy the commodity in cash market at $67/cwt.

Cash price is calculated as = Future price - basis point = $70-3 = $67/Cwt

Basis refers to differenec between future price and cash price.

Hedge position :

In Future market : Short April Futures @ $70/cwt

Buy April futures at $65/cwt ( given in part a)

So, Profit = $5/cwt ( $70-$65)

In cash Market :

Bought At $67/cwt

Sold at $ 63/cwt ( Calculated as $65/cwt i.e future price - 2 basis point(narrowed by 1 basis))

So, Loss of $4/Cwt

Net Profit = $1/cwt ( Difference between future and cash market)

b) Realised price in April if the basis has remain unchanged i.e 3 basis :

In future market :

Short Sell at $70/cwt

Bought at $72/cwt

Loss of $2/cwt

In cash market :

Bought at $67/cwt

sold at $69/cwt ( $72/cwt - 3 basis )

Profit = $2/cwt

Net Realised position = difference between cash and future market = ZERO