Question 4:

A. Draw and explain a payoff diagram linking a cereal manufacturers profits to the price of wheat. Be sure to label axes. Explain how that diagram informs us about risk. Should we assume that the manufacturer should hedge that risk? (If it makes it easier for you, you can make up some numbers of starting price and profits).

B. Draw and explain a payoff diagram for a futures position in wheat that could be beneficial to the cereal manufacturer. Be sure to specify whether the position is long or short. Combine with the diagram from (a) to show how hedging works.

C. Suppose there are call and put options on wheat. How could the cereal manufacturer use an option on wheat to reduce their risk. Show using a payoff diagram what the option payoff looks like and how it reduces risk.