Consider a corn farmer, who will harvest 20,000 bushels of corn in 3 months. Usi
ID: 2750586 • Letter: C
Question
Consider a corn farmer, who will harvest 20,000 bushels of corn in 3 months. Using the proceeds from the sale of his corn, he plans to pay back a loan in the amount of $140,000 that is due in 3 months. The price of corn today is $7 per bushel. Yet, the farmer receives some news indicating that the price of corn might substantially change within the next 3 months. The farmer gets nervous, as an adverse price change in corn price might render him unable to make his payments. Which of the following alternatives would you recommend to him? • Buy futures contracts for 20,000 bushels with a futures price of $7 and delivery in 3 months. • Sell futures contracts as they are outlined in the previous alternative. • Buy European put options for 20,000 bushels with a strike price of $2 per bushel. Explain your answer by describing his profit in various states of the world
Explanation / Answer
Correct answer is B
A is incorrect because through that farmer i having double the price exposure. If spot priceis 5 , he faces a loss of 2 on the spot and also a 2 $ loss on future as he is buying it at 7 dollar when it is available at 5 in the spot market
B is correct because if spot price after 3 months is 5 , although he faces loss on his actual stock to the tune of 2 dollar sbut he gains on the futures as he is can sell at 7 although the price is 5. thus the loss on spot is covered with gain in future helping him lock a price of 7
C is incorrect because strike price is 2 . although this behaves similar to option b , but because the strike price is 2 instead of 7, the option is not covering for the loss on spot price if the price is between 2 and 7.
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