Question 5: (9 marks) You are the chief operating officer at Breakkie Co. which

Question

Question 5: (9 marks) You are the chief operating officer at Breakkie Co. which produces breakfast cereal and needs 150,000 bushels of corn in March 2017. Suppose today is November 10 2016 and corn future contract for March 2017 delivery has a price of $4.05 per bushel. You are concerned that corn price might go up between now and March 2017 Required: (a) How can you use corn future contract to hedge your firm's risk exposure? What is the total cost you will be effectively locking in? 4 marks) (b) Suppose the market price of corn is $4.25 per bushel in March 2017, what is your firm's profit or loss on (5 marks)| the future position?

Explanation / Answer

a) If we are concerned about the corn price rise, we will buy March futures at $4.05 so that our cost is fixed. Total cost that we will lock is 4.05*150,000 = $6,075,000

b) Since market price has increases and we had bought the futures, we are at profit which is 4.25-4.05 = $0.2 per bushel. Total profit = $0.2*150,000 = $30,000

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