Evaluating Hedging With Futures Contracts

A large farming company likes to firm up prices for its agricultural products. It anticipates harvesting and selling 1,200,000 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 $5.00 per bushel. Futures contracts are available at $4.80 per bushel and six-month put option contracts with an exercise price of $5.00 per bushel are available for $0.35. A noninterest-bearing margin deposit of $200,000 is required if futures contracts covering the entire 1,200,000 bushels are sold. The company's current cost of borrowing is 5% 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

(c) Assume the spot price per bushel stands at $5.25 when 1,200,000 bushels of the commodity are harvested (not sold) and that commodity inventories are carried at market. 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
Inventory	Answer	Answer	Answer
Gain on growing crops	Answer	Answer	Answer
Loss on futures contracts	Answer	Answer	Answer
Interest income	Answer	Answer	Answer