Ben Barge Has Just Forward Contracted 1,000,000 Bushels of Soybeans in the Cash Market for $5

AGEC 489

Futures / Hedging / Options Homework

Ben Barge has just forward contracted a sell of 1,000,000 bushels of soybeans in the cash market for $5.00 / bushel to be delivered in May. Ben is also going to charge $0.01 / bushel shipping charge.

1) What are Ben’s initial costs?

2) If price does not change, how much does Ben stand to make or lose on this transaction?

3) If the price increases to $5.50 in May, does Ben lose or gain money? How much?

4) If the price decreases to $4.50 in May, does Ben lose or gain money? How much?

5) Worried about risk and losing all his money, Ben decides to enter the futures market and hedge. Current May soybeans future price is $5.15. Assume the basis’ does not change (recall basis = cash price - futures) and it costs $30/roundtrip in the futures market. Since Ben sold in the cash market, what should he do in the futures market? Assume his future contract is for the same amount of soybeans as the forward cash contract. What is the basis?

6) If the price increases to $5.50 in May, does Ben lose or gain money? How much?

7) If the price decreases to $4.50 in May, does Ben lose or gain money? How much?

8) What did the hedge do for Ben? Why would someone do this? This is an example of a perfect hedge.

9) If the price increases to $5.50 and the basis changes to $-0.10 in May, does Ben lose or gain money? How much?

10) If the price decreases to $4.50 and the basis changes to $-0.10 in May, does Ben lose or gain money? How much?

11) What did the hedge do for Ben? Why would someone do this? Compare to the example with no hedge. This is an example of bias risk.

12) Without doing the math, how would the answers to questions 9-11 change if the basis had increased to say $-0.20?

13) Instead of buying a futures contract, Ben decides the best method to manage risk is to enter the options market. Should he buy a call or a put?

14) If the cost of an option is $0.03 / bushel at a strike price of $5.00 plus a $10 brokerage fee, what does it cost Ben to buy the correct option for all the 1,000,000 bushels of soybeans?

15) Ben buys a call option at the strike price of $5.00 / bushel. If the price increases to $5.50 in May, does Ben lose or gain money? How much?

16) Ben buys a call option at the strike price of $5.00 / bushel. If the price decreases to $4.50 in May, does Ben lose or gain money? How much?

17) What did buying the option do for Ben? This example has no basis risk.

18) Options are basically acting as what. Think about class discussions, especially the lecture on medical economics and futures.

19) The above is a buying hedge. In general, how would your answers change if Ben had been involved in a selling hedge?