QUESTION 5 10 points Save Answer John and Tom enter into a futures contract in w
ID: 1162262 • Letter: Q
Question
QUESTION 5 10 points Save Answer John and Tom enter into a futures contract in which John agrees to deliver 500 crates of coffee to Tom one year from now Tom agrees to pay a price of S200 per crate A year from now. John and Tom find that the market price of coffee is $210 per crate How might they make a cash settlement on the contract? A Tom will offer $5,000 to John and deliver the 500 crates of coffee B John will offer $5,000 to Tom and not deliver any crates of coffee C. Tom will offer S5000 to John and not deliver any crates of coffee D John will offer 55,000 to Tom and deliver the 500 crates of coffeeExplanation / Answer
If the price of coffee is $210 per crate and the contract price is $200, then
John will offer $5000 to Tom and not deliver any crates of coffee.
It is so because
Cash Settlement is a method of settling forward contracts or futures contracts by cash rather than by physical delivery of the underlying asset. The parties settle by paying/receiving the loss/gain related to the contract in cash when the contract expires.
Here John and Tom are the parties who make the future contract and the difference between the spot price and contract price is $10 per crates of coffee. And they agrees to 500 crates of coffees means the amount of profit or loss is $10*500 = $5000.
Here the contract is settled by cash settlement it means the transfer of profit of $5,000 from seller to buyer. It is so because when they do contract the price is $200 and spot price is now $210, it means that the seller (John) earn a profit of $5,000 on the sale of 500 crates if he sell them in the open market at current price or spot price while the buyer (Tom ) who expect to buy 500 crates from the seller, will loss $5000 if he buys from the open market so in cash settlement of the contract the seller(John) will offer this $5000 to the buyer(Tom) so that his loss could be settled and he can buy it from the open market at the same price they decide on the contract. And also he will not deliver any crates to Tom.
So option b) is correct.
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