1. Hedging is a process whereby a person who owns a commodity uses the futures markets to transfer the price risk or to establish a price. Hedging involves opposite transactions in the cash and futures markets. Hedging can be used to handle price risk in storage and pre-harvest pricing decisions (NOTE: Basis=Futures Price - Cash Price) a. Suppose a grain elevator buys 100,000 bushels of corn in cash market on Apr 18 at $1.90/bushel and expect to deliver it on Apr 25 through cash market. He has to store it for one week and may face cash price fluctuations until the product is sold (for now, assume the cost of storage is zero dollars). On Apr 25 the cash market price of corn is $1.60 per bushel. i. What is the elevator's gain or loss if s/he traded only in cash market? ii. On Apr 18, s/he can sell his/her corn in the futures market at $2.40 per bushel and buy them back on Apr 25 at $2.00 per bushel. What is the gain or loss in the futures market through this hedging? iii. Calculate the Basis for both Apr 18 and Apr 25 transactions. iv. Calculate the total return per bushel of corn to the grain elevator through such hedging in the futures market. V. What is the net profit/loss through above hedging in the futures market? b. Now let's assume that storage from Apr 18 through Apr 25 has a cost of 20 cents ($0.20) per bushel of corn. i. In this scenario, what is the elevator's total loss/gain if s/he buys and sells only in the cash market? ii. Let's assume that the Basis on Apr 18 (which is $0.50) did not change. What should the Basis be on Apr 25 for the elevator who buys in the futures market to have his total loss in both cash market and storage cost covered? iii. What is his/her new futures market price where he/she buys the futures contract back on Apr 25? c. Now looking at the strengthening Basis (narrowing difference between futures and cash market price), he/she decides NOT to sell his cash corn on Apr 25 at $1.60/bu. The Basis as of Apr 30 is expected to be $0.10. Now he/she decides to wait until Apr 30 and sell in cash market at $1.70/bu. The extra cost of storage from Apr 25 through Apr 30 is $0.05/bu. i. What is the total loss/gain if s/he delivers only in cash market as of Apr 30? ii. What is the futures market price as of Apr 30 which s/he buys the contract back at? iii. What is the total gain per bushel in the futures market trading? iv. What is the total return per bushel of corn if s/he sells as of Apr 30? What is the net gain for the farmer through this hedging in the futures market
