A major cattle feeding operation has entered into a firm commitment to buy 100,000 bushels of corn to be delivered to its feed lot in Kansas. The corn is expected to be delivered in 90 days. The company is committed to pay $1.50 per bushel. If corn yields are greater than expected, the price of corn could decline and the company would experience higher operating costs than necessary as a result of the commitment.
In order to protect itself against falling corn prices, the company purchased an option to sell corn in 90 days at a strike price of $1.51 per bushel delivered to a facility in Nebraska.
1. Assuming that the company designated the swap as a fair value hedge, identify several critical criteria that would need to be satisfied in order to justify this classification.
2. Identify several factors that would suggest that the company’s hedge would qualify as being highly effective in reducing the risk associated with the firm’s commitment to buy 100,000 bushels of corn.
3. Explain why an option to sell corn rather than corn futures may provide the company with more flexibility.
4. Assume that at the time of acquiring the put option, the price of corn was less than $1.51.
Explain why the option had a value of more than zero at inception.
5. Assume that one of your colleagues made the following comment: ‘‘an option can never have a negative value; therefore, you can never lose money on an option.’’ Discuss whether or not you agree with your colleague.
6. Assuming that only the intrinsic value is used to assess effectiveness, explain how the option’s time value affects earnings prior to the end of the commitment.