Economics 168 Asset Pricing and Risk Management Fall 2009

Problem Set 6: FUTURES

1. A Wheat farmer expects to harvest 60,000 bushels of wheat in September. In order to pay for
the seed and equipment, the farmer had to draw $150,000 from his savings account on
January 1 this year. He earns 4.8% p. a. on the savings account, and interest on the account
is compounded monthly. The farmer is worried about fluctuations in the wheat price and
wishes to hedge the position. Wheat futures are currently quoted as $3.41 per bushel. Wheat
futures contracts are 5,000 bushels per contract [i.e., if you buy one wheat futures contract at
a price of F per bushel, you are contracting to purchase 5,000 bushels of wheat on the
futures expiration date at a cost of (5000 x F) dollars.]

(a) Should the farmer buy or sell futures to hedge himself against changes in the price of
wheat? How many contracts should he buy/sell?

(b) What is the net profit the farmer will make on his harvest, assuming he carries out the
futures transaction from part (a), and his harvest yields exactly 60,000 bushels in
September? Include in your calculations the loss of interest on the $150,000 that the
farmer had to draw from his savings account to purchase seeds and equipment. Assume
that the Futures transaction takes place on the last day of September, and that his costs
for transporting the harvested wheat to the counterparty in the futures transaction are
negligible.

(c) At what futures price would the farmer exactly break even on the transaction?

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(d) Suppose that December wheat futures (which settle on December 31 ) are trading at
$3.505 per bushel, and the farmer could store his harvested wheat between the end of
September and the end of December for a cost of $1,200 per month (paid at the end of
each month for that month's storage). Should the farmer store the wheat and use the
December futures contract, or should he stick with the September contract and sell his
wheat immediately upon harvesting it? (Don't forget to include the loss of interest on the
storage costs.)

2. Suppose that your company makes a sale of machines to a Swiss customer. The sale price
is 8 million Swiss Francs payable at the end of the year. The forward rate for the December
payment date is 0.8 SFR/$. You are worried that the Swiss Franc will move between now
and the end of the year. How can you hedge against the exchange rate risk?