Question

Edit question A corn farmer expects to harvest $ 50,000 bushels of corn by mid-July 2010.

Price per bushel = $ 3.70

A future contract on corn maturing on July 12, 2010 is available on May 3, 2010 with following specifications.

Date                  Future contract closing price per contract ( US$)

May 3, 2010

May 17, 2010                    3.80

May 31, 2010                     3.60

June 14, 2010                     3.40

June 28, 2010                    3.50

July 12, 2010                       3.50

If the corn farmer in the example above harvests 60,000 bushels, what amount will he receive? What if he had not hedged his position? If the corn farmer in the example is able to harvest only 40,000 bushels and the price per bushel rises to US$3.90 due to short supply of corn, will his exposure be completely hedged? Why? Why not? Support your answer with calculations. (5 points

Answer 1

The whole futures market was established to help hedge the investments. Considering the price of the contracts, if the farmer is willing to enter in no future contracts at all the values as per the question he will earn from his investments are as below -

If the farmer sells his harvest of 60,000 bushels at price of $ 3.70 per bushel, the prices would be $ 2,22,000

If hedged,

The farmer has a expectation of rise in price, but he is unsure, if the crop prices would sustain, hence he promise to sell his crop at a predetermined price by entering a futures contract and hence hedging his current deal, So if the market price on the day is higher or lower he can ensure a fix profit.

The calculation is given below,

The farmer set a deal with a producer at $ 3.70 per bushel at the given time of mid July, and than enter the futures market and buys a 12 July contract at $ 3.50, by doing so the price window is fixed as the amount can go higher or lower than $ 3.50 on that day but the contract window holds the fixed profit at $ 0.20.

The example -

If the MP (Market Price on 12 July) is at $ 3.90

The deal was struck at $ 3.70. The farmer is bound to incur losses of 0.20 $, but the price of his futures contract will earn him $ 0.40 profit. Hence if we see the whole scenario the farmer fixed his profit at $ 0.20 per bushel.

If the contract ends at $ 3.90 but the produce fell short, then,

Contract entered for 50,000 is a 10 lot contract (the lots are 5000 bushels per lot)

But the farmer only produced 8 lots of it,

That means he will be paid for 8 lots but has to produce the rest 2 lots i.e. 10,000 Bushels.

Let us see how,

50,000 Bushels, is the number of bushels farmer has promised the producer.

The farmer fell short of 10,000 at a price of $ 3.90

He made a loss of $ 0.20 (Market price on July 12, $ 3.90 - contract price between them $ 3.70) on each the 40,000 bushels which carries out to be $ 8,000

If the position is hedged, He bought 50,000 bushels i.e. 10 lots of bushels at $ 3.50 and has sold them at $ 3.90 the market price. This position gives him a profit of $ 20,000.

So if he needs to buy those additional 10,000 bushels it would be at market price that will be with the losses of additional $ 0.20 per bushel as he has already received $ 3.70 per bushel this would make the losses up to $ 0.20 * 10,000 bushels which is $ 2,000.

The total profit would be - 20,000 - (8,000 + 2,000) = $ 10,000,

But if the position was not hedged the losses would be of $10,000 with no profit to the farmer.