5. Hedging strategy to protect against rising prices Aa Aa A long hedge is a ris
ID: 2788438 • Letter: 5
Question
5. Hedging strategy to protect against rising prices Aa Aa A long hedge is a risk management strategy in which a company can lock in the price of the commodity that can be purchased in the future, Consider the case of Green Grains Inc., a flour manufacturer: In May, Green Grains Inc. placed a long futures position to hedge against a possible increase in the price of wheat, a key raw material in the production of flour. Based on the selling price that Green Grains earns from its customers, the maximum price that it can pay for wheat is $7.00 per bushel to break even. You also have the following information and assumptions: . The current spot price of wheat is $5.25 per bushel, and the September futures price of the commodity is $5.95 per bushel. At $5.95 per bushel, the company will easily break even and make some profit, so it wants to lock in this purchase price for delivery in September . Wheat futures contracts trade in a standard size of 5,000 bushels. To meet its production requirements, Green Grains buys 20 future contracts. In September, the spot price of wheat rose to $8.40 per bushel, and the price of wheat futures rose to $8.96 per bushelExplanation / Answer
Total Future contracts = 20
Total bushel in 1 contract = 5000
Total quantity of wheat = 20 * 5000 = 100,000 bushel
In Cash Market
Break-even price = $ 7.00
Spot price in September = $ 8.40
Therefore company will make a loss here since spot price is greater than break-even price.
Total Loss = (breakeven - spot price) * Quantity
Total loss = (7 - 8.40) * 100000
= $ - 140,000
In future market
Forward contract price = $ 5.95
Spot price in September = $ 8.40
Here company will make a profit because actual buy price is $ 5.95 and spot price is $ 8.40
Total profit = (Spot price - forward price) * Quantity
= (8.40 - 5.95) * 10000
= $ 245000
Net profit/loss = Profit/Loss in cash maket + Profit/loss in futures market
= $ - 140000 + $ 245000
= $ 105000
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