Question

A trader enters into a short forward contract on 100 million yen. The forward exchange rate is $0.008 per yen. How much does the trader gain or lose if the exchange rate at the end of the contract is (a) $0.0074 per yen; (b) $0.0091 per yen? 5. A cattle farmer expects to have 120,000 pounds of live cattle to sell in three months. The live-cattle futures contract on the Chicago Mercantile Exchange is for the delivery of 40,000 pounds of cattle. How can the farmer use the contract for hedging? From the farmer’s viewpoint, what are the pros and cons of hedging? Who is on the other side of the trade (Explain his/her strategy)?

Answer 1

a)The trader sells 100 million yen for $0.0080 per yen when the exchange rate is $0.0074 per yen.

The gain is 100*0.0006 millions of dollars or $60,000.

b)The trader sells 100 million yen for $0.0080 per yen when the exchange rate is $0.0091 per yen. The loss is 100*0.0011 millions of dollars or $110,000

5. The farmer can short 3 contracts that have 3 months to maturity. If the price of cattle falls, the gain on the futures contract will offset the loss on the sale of the cattle. If the price of cattle rises, the gain on the sale of the cattle will be offset by the loss on the futures contract. Using futures contracts to hedge has the advantage that it can at no cost reduce risk to almost zero. Its disadvantage is that the farmer no longer gains from favorable movements in cattle prices.