ttempts B. Hedging strategy to protect against rising prices A long hedge is a r

Question

ttempts B. Hedging strategy to protect against rising prices A long hedge is a risk management strategy in which a company can lock in the price of the commodity that can Average: 13 Aa Aa purchased in the future. Consider the case of wavy Wheat Inc., aflour manufacturer: placed a long futures position to hedge against a possible increase in the price of wheat In May, Wavy Wheav Inc, key raw material in the production of flour. Based on the selling price that wavy Wheat eams from its customers the maximum price that it can pay for wheat is $7.15 per bushel to break even, You also have the following information and assumptions . The current spot price of wheat is $s 36 per bushel, and the September futures price of the commodity is $6.08 per bushel At $6.08 per bushel, the company will easay bresk even and make some profit, so it wants to lock in this purchase price for delivery in September wheat futures contracts trade in Wheat buys 20 future contracts . standard size of SO00 buset To meet its production requrements, Wpvyh In September, the spot price of wheat rose to i ss per bushe, and the price of wheat futures rose to $9.15 per bushel Based on your understanding at the long hedge strategy, compie the transactions in the Aturet and cash markets Futures Market Cash Market Net gain or loss in the futures mariket Net gaih or oss in the cash market O $250,000 O -343,000 O-471 ,000 -5605:000 o ¡915,000 O +307,000 thus, the gain and loss offset each öther, and the comeuny te efts thom Pacing the song e net proft of the cemeatir epe The comspany tems and helps pronct the brseturetto purchasw a commodity apainst isng pmces

Explanation / Answer

Cash market

You break even at $7.15. Therefore, any amount above that will be a loss. Since, spot price in the cash market is $8.58 per busher -

Loss = ($7.15 - $8.58) x 5000 x 20 = (-)$143,000

Futures market

Under futures, you enter a long position or agreement to buy the wheat bushels @$6.08. So, on maturity you will buy @$6.08 and sell on market @$8.58 and will have a gain.

Gain = ($8.58 - $6.08) x 5000 x 20 = $250,000

Net Profit = $250,000 - $143,000 = $107,000

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