The chart below shows several strike prices for puts on the corn futures contrac
ID: 2796896 • Letter: T
Question
The chart below shows several strike prices for puts on the corn futures contract for March 2018 delivery. A producer is harvesting 100,000 bushels of corn in October and plans to store the grain until March 2018. She also plans to use options to hedge her grain until March 2018. Knowing that her break-even price is $3.20/bu (i.e. she needs to sell her corn at least for $3.20/bu to cover her production costs), her expected basis for March is –$0.30/bu and the cost of carry is $0.04/bu/month, which put should she choose? Make sure to explain in detail how you would make this decision based on all relevant factors in this problem.
strike ($/bu) premium ($/bu)
3.40 0.02
3.50 0.04
3.60 0.08
3.70 0.13
3.80 0.20
3.90 0.29
4.00 0.38
4.10 0.48
4.20 0.57
4.30 0.67
Explanation / Answer
In futures trading, the term "cash" refers to the underlying product). The basis is obtained by subtracting the futures price from the cash price. The basis can be a positive or negative number. A positive basis is said to be "over" as the cash price is higher than the futures price. A negative basis is the cash price is lower than the futures price.
As put strikes are on future prices and not on spot, we must select the option with stike of 0.30 above 3.20.
Also, we need to cover for cost of carry which is $0.04/bu/month , i.e. $0.20/bu for 5 months (Nov to Mar).
Therefore, stike to be selected = 3.20 + 0.30 +0.20 = 3.70
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