Question

6. It is currently November 15 and a hog farmer expects to have 200,000 Ibs. of hogs for sale in April of next year. He decides to engage the futures market to hedge his production. The November cash price is 65 cents per pound (the amount he needs to earn to make an acceptable profit). The November 15 futures market price for April delivery is 55 cents per pound. The actual cash price in April is 45 cents per pound, which the April futures price is 35 cents per pound A. Use a table for a futures and cash markets (like the one of the miller from the slides) to demonstrate how the farmer could hedge against the risk of a fall in the price of hogs between November and April. B. Is the farmer better off hedging than he would have been had he not hedged? Explain.

Answer 1

The farmer will produce 20,000 lbs of hogs in April 2016.

There is a risk of market price of hogs falling in the future. Thus, the farmer enters into hedging through futures.

Under futures, you undertake a contract to fix a price today (T=0) at which hogs will be sold in the future (T=n)

Here are the spot & futures prices of hogs as given in the question

Particulars	Nov-15	Apr-16
Quantity		20,000 lbs
spot price	$.65/pound	$.45/pound
futures price	$.55/pound	$.35/pound

Income can be calculated as = 20,000 * rate (i.e. spot price or future price). For example, spot income of November = 20,000*.65 = $13,000

spot income	$                                    13,000	$                                      9,000
futures income	$                                    11,000	$                                      7,000

PART 1

If the farmer enters into a futures in November 15 (T=0) for sale of hogs in April 2016 (T=1) at $0.55/pound, he is obligated to sell hogs in April at this price.

If actual prices in April are higher than the futures price of November

Head	Scenario	Actual Price in April	Futures price for April decided in November	Result	Reason
Given	1	$.45/pound	$.55/pound	Farmer gains	He contracted in advance to sell his hogs at a price higher than the actual price
Assumed	2	$.65/pound	$.55/pound	Farmer loses	He contracted in advance to sell his hogs at a price lower than the actual price

Since the futures price at T=0 (i.e. November) are higher than that at T-1 (i.e. April). Hence, the farmer should hedge using November futures.

PART 2

Clearly the actual prices in April ($.45 per pound) are lower than the futures price for April contracted in November ($.55 per pound).

Hence, the farmer will earn more if he hedges.

Income if futures are taken = 20,000*$.55 = $11,000

Income if futures are not taken = 20,000*$.45 = $9,000

Hence, the farmer earns more by $2,000 if he hedges. So, the farmer should hedge.