Suppose that you are a wheat farmer. Answer the following questions: 1. It is Se

Question

Suppose that you are a wheat farmer. Answer the following questions:

1. It is September, and you intend to have 50,000 bushels of wheat harvested and ready to sell in November. The current spot market price of wheat is $2.50 per bushel, and the current December futures price of wheat is $2.75 per bushel. Should you buy or sell December wheat futures? If each wheat futures is for 5,000 bushels, how many contracts should you buy or sell? How much will your position be worth in the futures market in September?

2. It is now November, and you sell 50,000 bushels of wheat at the spot price of $ 2.60 per bushel. If the December futures price is $2.85 and you settle your position in the futures market (note that you are settling your position before the settlement date on the contract, which is December), what was your gain or loss in your futures market position? Did you completely hedge your risk from price fluctuations in the wheat market? Explain.

Explanation / Answer

Answer-1

The farmer is going to be selling the wheat in the future so he is concerned that the future spot price will be low, which would result in low revenues from the sale of his wheat. He can hedge this risk by selling futures on wheat. This short position in the futures contract obligates him to sell the wheat in the future at the delivery price (i.e. the future price at the inception date of the contract).

Assuming this expectation is correct, the farmer is going to harvest 50,000 bushels in September. Since each contract is for 5,000 bushels, he will need to sell 50,000/5,000 = 10 contracts. And, since the harvest will take place in September, he should sell September contracts

The current worth of the contract will be = $2.5 x 50000 = $125000

Answer-2

If the wheat is sold at a future price of $2.6 per bushel then:

Total revenue from this sale = $2.6 x 50000 = $130000

The gain/loss for the seller of futures is calculated by (F – St) x Quantity

Here F = $2.85 and St = $2.6 and Quantity = 50000 bushels

Therefore gain = ($2.85-$2.6)x 50000 = $12500

Therefore total gain = $130000+$12500 = $142500

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