Question

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You are a small feedlot owner. You have 250 steers that you are feeding that you expect to slaughter in late November. They should weigh 1250 pounds at slaughter. You want to hedge about half of these steers. Create a trade for the Chicago Mercantile Exchange in a word document. Include the date, contract size, and long or short. (Hint: the Live Cattle contract is for slaughter cattle and each contract is 40,000 lbs.)

You have enough corn on hand to feed these steers. However, after you sell them in November, you will be buying more calves to feed and you need to buy corn for them. You want to protect against possibly higher corn prices by executing a long hedge. (Assume you need 15,000 bushel of corn, three contracts.) Do the same for this contract, date, size and long or short, in the same document.

Answer 1

Long a call option depicts protecting oneself from the probability of rising price of the underlying commodity (Which is beneficial in case you want to buy a commodity in future, as the price will be fixed at say, X. For eg: Even when price moves from 100lbs to 200lbs, the owner will pay only 100lbs)

Long a put contract means protecting oneself from the expected fall in price of the underlying commodity (Which is beneficial in case you want to sell the commodity in future as the sell price will be fixed at say, X. For eg: Even if the price of the commodity falls from 200lbs to 100lbs, the owner will receive 200lbs only)

In the first part of the question:
The feedlot owner wants to protect himself from the fall in the weight of the steers on slaughter. Thus, he will go long with 125 contract with put option and strike price (X) of 40,000lbs each and expiry date of 30th November.

With the similar concept as above,
In the next para, the owner wants to protect himself from the probable increase in the price of the corn to feed the calves. Thus in order to hedge the risk of increse in price , he will go long a call option which will fix his payout at the strike price, X of the contract. Even if the prices go up, his payout will be fixed.
Therefore, he will go long with 3 contracts with a call option of an expiry date of 30th November at a strike price (X) of 56*5000 = 2,80,000lbs

Total bushels to be hedged = 15000 (As given)
Total number of contracts =3 (As given )
Each contract will hedge 15000/3 = 5000 bushels

*It is assumed the price of one bushel of corn is 56lbs