Question 1: Consider a bakery that estimates its requirement of wheat in May as 50,000 bushels. The manager of the bakery can hedge against price risk by going long on 10 May wheat futures contracts at the currently prevailing futures price of $8.65 a bushel for May delivery and then accepting delivery at this price in May. (Note futures contract is already at maturity in May)

• Calculate the cost to the bakery if it takes delivery?( 1 mark)
• Instead of taking the delivery the manager can take positions in the futures and spot market. For example, take 10 long May wheat futures contract at the prevailing futures price, close the futures at the future price (Ft) prevailing then. Long 50,000 bushels of wheat in the spot market in May at the spot price (St) prevailing then. Calculate the gain or cost in the futures market and spot market? What is the overall net cost to the Bakery? Explain the outcome and compare with your answer to part (a).(5 marks)

Question 2: A speculator can choose between buying 100 shares of a stock for $40 per share and buying 1000 European call options on the stock with a strike price of $45 for $4 per option. For second alternative to give a better outcome at the option maturity, the stock price must be above $55 or $50? Explain. (2 marks)

Assignment 1 - Semester 1, 2016 Due April 8, 4pm Question 1: Consider a bakery that estimates its requirement of wheat in May as 50,000 bushels. The manager of the bakery can hedge against price risk by going long on 10 May wheat futures contracts at the currently prevailing futures price of $8.65 a bushel for May delivery and then accepting delivery at this price in May. (Note futures contract is already at maturity in May) (a) Calculate the cost to the bakery if it takes delivery? ( 1 mark) (b) Instead of taking the delivery the manager can take positions in the futures and spot market. For example, take 10 long May wheat futures contract at the prevailing futures price, close the futures at the future price (Ft) prevailing then. Long 50,000 bushels of wheat in the spot market in May at the spot price (St) prevailing then. Calculate the gain or cost in the futures market and spot market? What is the overall net cost to the Bakery? Explain the outcome and compare with your answer to part (a). ( 5 marks) Question 2: A speculator can choose between buying 100 shares of a stock for $40 per share and buying 1000 European call options on the stock with a strike price of $45 for $4 per option. For second alternative to give a better outcome at the option maturity, the stock price must be above $55 or $50? Explain. (2 marks) Question 3: The spot price of an investment asset is $30 and the risk-free rate for all maturities is 10% with continuous compounding. The asset provides an income of $2 at the end of the first year and at the end of the second year. What is the three-year forward price? (2 marks)