Question

1. Suppose you are Chief Financial Officer at Beazley Confectionery, Inc. and you purchase a large quantity of cocoa each month. You are concerned about the price of cocoa one month from now. You want to guarantee that you will not pay more than $0.80 per pound for forty-five thousand pounds. You do not want to pay for insurance, but you do want to lock in a price of $0.80 per pound for forty-five thousand pounds.

1. Show the economics of a futures transaction for spot prices on delivery date of $0.70, $0.80, and $0.95.
2. What is the variability of Beazley’s total outlays under the futures contract?
3. If at the time of delivery, cocoa is $0.70 per pound, should you have foregone entering into the futures contract? Why or why not?

Answer 1

The spot price is the current price in the marketplace at which a given asset—such as a security, commodity, or currency—can be bought or sold for immediate delivery. Whereas, a futures price is an agreed upon price for future delivery of the asset.

In case of Beazley Confectionery its CFO gets into a future contract for Cocoa per month at $0.80 per pound for 45000 pound of cocoa.

a) The economies of future transaction when the spot price on the delivery date is

• $0.70 :- Realized saving/loss on future delivery on this day = (Spot - Future)* Quantity= ($0.7-$0.8)*45000 = $4500
• $0.80 :- Realized saving/loss on future delivery on this day = (Spot - Future)* Quantity= ($0.8-$0.8)*45000 = $0
• $0.95 :- Realized saving/loss on future delivery on this day = (Spot - Future)* Quantity= ($0.95-$0.8)*45000 = ($6750)    Hence, Beazley would have incurred loss of $6750 if spot price would be $0.95 and they would be without lock in whereas there would have been a gain of $4500 if spot price would be $0.

b) The variability of Beazley's total outlay under the future contract will be $0.80*45000 = $36000

c) No we shouldn't have foregone entering into this contract because we can't predict the future price of cocoa and while its $0.70 per pound right now it's only with the hindsight we have this information. while if we get into the contract we lock in the price of one of our crucial ingredient which would bring some consistency in our profit.