You are a coffee dealer anticipating the purchase of 82,000 pounds of coffee in

Question

You are a coffee dealer anticipating the purchase of 82,000 pounds of coffee in three months. You are concerned that the price of coffee will rise, so you take a long position in coffee futures. Each contract covers 37,500 pounds, and so, rounding to the nearest contract, you decide to go long in two contracts. The futures price at the time you initiate your hedge is 55.95 cents per pound. Three months later, the actual spot price of coffee turns out to be 58.56 cents per pound and the futures price is 59.20 cents per pound. a. Determine the effective price at which you purchased your coffee. How do you account for the difference in amounts for the spot and hedge positions? b. Describe the nature of the basis risk in this long hedge.

Explanation / Answer

a)Price, at which you entered into long position = 55.95 Cents/Pound
Future price three months later = 59.20 Cents/Pound
Gain from position = 59.20 – 55.95 = 3.25/Pound

Actual Spot Price = 58.56 Cents/Pound
Effective price for 75,000 Pounds (2 Contracts) = 58.56 – 3.25 = 55.31/Pound

Net Effective Price = [(75,000 x 55.31) + (7,000 x 58.56)] / 82,000 = 55.5874/Pound

b)Basis Risk = Current Future Price – Current Spot Price
=> 59.20 – 58.56 = 0.64 Cents/Pound

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