The producer\'s farm will be hit hard if the com price drops below $3.25 per bus
ID: 2724193 • Letter: T
Question
The producer's farm will be hit hard if the com price drops below $3.25 per bushel. Therefore the producer was considering hedge his position. He was considering four options: do nothing, hedge with forwards, hedge with futures and hedge with options. The market information is summarized below: The annual interest rate in the market was 5%. Assume there will no storage cost whatsoever. Futures quotes on March 17^th (Corn: 5.000 bu.; cents per bu.): Options quotes (American style) on March 17^th (Corn; 5,000 bu.; cents per bu.) Explain the producer's risk exposure. How can the corn price volatility affect his cash flow Estimate the producer's cash flow if he chooses not to hedge. Estimate the producer's cash flow if he chooses forward hedge. What are the pros and cons of forward hedge What are the pros and cons of futures hedge Estimate the producer's cash flow if he chooses options hedge. What are the pros and cons of the options hedgeExplanation / Answer
Answer
Answer (a)
Producer’s risk exposure is that corn price will down. If the corn price goes up, It will increase cash inflow of producer and If the corn prices goes down, It will decrease cash inflow of producer.
Answer (d)
Pros and Cons of Forward hedge
Forward contract is a non-standardized contract between two parties to buy or sell an asset at a specified time at an agreed price.
The advantages of forward contracts are as follows:
1) They can be matched against the time period of exposure as well as for the cash size of the exposure.
2) Forwards are tailor made and can be written for any amount and term.
3) It offers a complete hedge.
4) Forwards are over-the-counter products.
5) The use of forwards provide price protection.
6) They are easy to understand.
The disadvantages of forward contracts are:
1) It requires tying up capital. There are no intermediate cash flows before settlement.
2) It is subject to default risk.
3) Contracts may be difficult to cancel.
4) There may be difficult to find a counter-party.
Answer (e )
Pros and Cons of Futures hedge
The advantages of trading futures contracts:
1) The commission charges for futures trading are relatively small as compared to other type of investments.
2) Futures contracts are highly leveraged financial instruments which permit achieving greater gains using a limited amount of invested funds.
3) It is possible to open short as well as long positions. Position can be reversed easily.
4) Lead to high liquidity.
The disadvantages of trading futures contracts:
1) Leverage can make trading in futures contracts highly risky for a particular strategy.
2) Futures contract is standardized product and written for fixed amounts and terms.
3) Lower commission costs can encourage a trader to take additional trades and lead to over-trading.
4) It offers only a partial hedge.
5) It is subject to basis risk which is associated with imperfect hedging using futures.
Answer (g)
Pros and Cons of Options hedge
The Advantages of Trading Options are:
1) Options trading offers flexibility to the buyers as well as to the sellers. It can be used in a wide variety of strategies in order to make a profit from the ever changing market.
2) Financial leverage is another advantage of trading options. Investors can employ considerable leverage without committing to a trade.
3) They are less risky as compared to other types of trading instruments. Huge losses can be avoided as risk is limited to the option premium, so the maximum loss is the price you paid to purchase it (known as premium).
4) Hedging using options enables investors to manage risk and reduce potential risk.
The Disadvantages of Options Trading:
1) The cost of trading options can be higher on a percentage basis than trading the underlying stocks.
2) Options are so complex that it requires a close observation and maintenance.
3) The short selling of options is accompanied by unlimited risk.
4) Options will expire at a fixed point in time and lead to most trading expire worthless. This is applied to the traders that purchase options.
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