Question

Suppose you are a wheat farmer. You expect a new harvest of wheat three months from today. The price of wheat at the time of harvest in three months is uncertain. How can the farmer avoid the price risk?

Suppose you are a miller. You need to purchase wheat in three months from today. You are faced with the price risk, too. How can you have insurance for the price risk?

Answer 1

As a Wheat Farmer, I am worried that the prices of wheat may fall from current level in three months when the new harvest of wheat will come in the supply. I can sell the 3 month forward contract for wheat and lock my selling price today itself. In case, the market price does really fall after 3 months then I can sell at the pre-agreed price. However my assessment can go wrong too and prices may actually rise too but atleast I avoided uncertainity by getting into a 3 month forward sell contract.

If I were a miller and I am worried about price uncertainity of wheat getting costlier 3 months down the line, then I would get into a 3 month buy contract and lock my price today itself. Incase the prices does go up then I can buy the wheat at the pre-agreed price.I may incur some premiium charges in getting into the forward contract but at least I would avoid the uncertainity.

We can also look at other derivative products like Call,put if the commodity in question , that is wheat , is actively traded in commodities market. If yes, then being a Farmer, I can sell call of wheat and in case If I am a Miller, I can buy a Call.