Evaluating Hedging With Futures Contracts

A large farming company likes to firm up prices for its agricultural products. It anticipates harvesting and selling $1,000,000$ bushels of a particular commodity in six months. News reports and changes in forecasts cause fluctuations in the spot price for the commodity. The current spot price is $$5\mathrm{.}00$ per bushel. Futures contracts are available at $$4\mathrm{.}75$ per bushel. A noninterest$-$bearing margin deposit of $$200,000$ is required if futures contracts covering the entire $1,000,000$ bushels are sold. The company's current cost of borrowing is $4\%$ per annum.

$($a$)$ Explain the advantages and disadvantages of hedging the harvest's value with futures contracts.

Choose the correct answer.

An advantage is fixing the sale price of a commodity at the futures price when the contract is entered. A disadvantage is eliminating the possibility of a gain.

An advantage is tying up capital in a non$-$interest bearing margin account. A disadvantage is eliminating the possibility of a gain.

An advantage is eliminating the possibility of a loss. A disadvantage is fixing the sale price of a commodity at the futures price when the contract is entered.

An advantage is fixing the sale price of a commodity at the futures price when the contract is entered. A disadvantage is eliminating the possibility of a loss.

$($b$)$ Calculate the spot price six months hence at which the company is indifferent between not hedging and hedging with futures contracts.

Round per bushel price three decimal places.

Per bushel price Answer

$4\mathrm{.}746$

$($c$)$ Assume the spot price stands at $$5\mathrm{.}25$ per bushel when $1,000,000$ bushels of the commodity are harvested and sold. Explain, using calculations as needed, how the company's financial statements will differ without hedging compared to hedging with futures contracts.

Remember to use negative signs with your answers when the financial statement effect is a credit.

Financial Statement Effects

Debit $($Credit$)$

No Hedge Hedge with Futures Contracts Difference

Cash Answer Answer Answer Answer Inventory Answer $000$

Gain on harvest Answer Answer Answer $0$

Loss on futures contracts $0$ Answer Answer

Interest Expense Answer Answer Answer