Question

In: Economics

Suppose there is an anticipation of sharply declining prices due to remaining large Southern Hemisphere supplies...

  1. Suppose there is an anticipation of sharply declining prices due to remaining large Southern Hemisphere supplies during summer when U.S. corn crop is planted. A corn producer is considering buying a put option to establish a minimum price for the sale of a portion of 2018 harvest. November 2018 futures are trading at $5.20/bu at Chicago Mercantile Exchange. The premium for a $5.20 strike price is 30¢/bu. The basis is expected to be 10¢/bu under at harvest.

a) What is the minimum selling price that can be established by buying a $5.20 November put?

b) With a guaranteed loan rate of $5.11 per bushel, does the purchase of the $5.20 put make sense at this point in time? Yes /No. Justify your answer.

2.

A producer is harvesting corn during late Fall and has decided to make harvest delivery at a basis of 45¢ over December futures. The cost of production is $2.25/bu. His speculation is that the basis level is extremely strong from an historical perspective and that basis is likely to weaken by 15¢ to 20¢/bu. as harvest progresses. Also, corn futures may have a chance to make a comeback after harvest pressure subsides, perhaps to $3/bu. December corn futures are trading at $2.59. The premium for a $2.60 March call is trading at 18¢/bu. The producer figures that buying a March call gives the corn market a chance to work higher and that the time value of the May or July Call makes the strategy less appealing due to the higher cost of the premiums.

Should the producer buy the March $2.60 call at this time? Yes /No. Justify your answer.

Solutions

Expert Solution

The put option is the agreement enabling the owner the privilege to sell a certain amount of basic security at a fixed price within a defined time period, but not the obligation. The fixed price the buyer will sell at the put option is termed as the strike price.

(a) The minimum selling price is calculated as the strike price determined at the put option minus the net premium cost minus the options trading costs minus the expected basis. So, the minimum selling price that can be established by buying a $5.20 November put should be $4.80.

(b) No. With a guaranteed loan rate of $5.11 per bushel, does the purchase of the $5.20 put makes no sense at this point in time. This is because the minimum selling price is $4.80 and the purchaser has already paid $5.20 to the seller i.e. a premium to get the privilege to sell at $4.80 in case the price goes lower.

2. The producer should buy the March $2.60 call at this time. This is because doing the same will be more profitable for the producer. With the cost of production $2.25/bu and the premium for a $2.60 trading at 18¢/bu, the chance of receiving subsidies from the government is also high according to the historically proven speculation from the producer’s side. Moreover, the supply of corn will be relatively less in summer than in December and demand for corn will exceed its supply so chances of rising its price are high. Since the producer is an experienced one who can evaluate the calculation and make predictions about future prices and profits throughout his mathematical calculation also, so he or she should advance toward the March call.


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