Question

Question 3. A company will buy 1000 units of a certain commodity in one year. It decides to hedge 80% of its exposure using futures contracts maturing in 13 months. The spot price and the futures price are currently $100 and 90, respectively. If the spot price and the futures price in one year turn out to be $112 and $110, respectively. What is the average price paid for the commodity?

can someone please explain all steps and mechanism behind this to someone that doesnt understand WITHOUT COPY PASTING old answers which will be reported for plagiarism.

Answer 1

Answer

Future Contract:

A futures contract is a legal agreement to buy or sell a particular commodity asset, or security at a predetermined price at a specified time in the future.

The buyer of a futures contract is taking on the obligation to buy and receive the underlying asset when the futures contract expires.

The seller of the futures contract is taking on the obligation to provide and deliver the underlying asset at the expiration date.

Futures are also often used to hedge the price movement of the underlying asset to help prevent losses from unfavorable price change.

Company will buy 1000 units of a certain commodity in oner year.

Company entered in the hedging contract for 800 units(1000 x 80%) at a future price of $90. maturing in 13 months.

So, Company will buy 200 units after one year at spot price.

Calculation of profit on hedge of Future contract:

Spot price after one year is $112.

As company is already entered in future contract,

company wil buy 800 units at contracted future price of $90. i.e 800 x $90 = $72,000

So, Profit from future is $17,600(800 x $112-$90).

Company will buy another 200 units at spot price of $112. i.e 200 x $112 = $22,400

Calculation of Average price paid:

Average price = ($72,000 + $22,400) / 1000 units

Average price = $94.4