Question

West Ridge Farms Limited is expecting to harvest 75,000 bushels of corn this fall. The company's CEO is concerned that corn prices may decrease by December when the crop has been harvested and ready for sale. To hedge the risk of a decrease in price, she enters into a futures option contract. Each option contract is for 5,000 bushels, and the CEO wants to hedge the entire crop. The December option contract for corn has a strike price of USD 4.00 per bushel. The cost of the option is 20 US cents per bushel.

a. Should West Ridge Farms buy or sell a call option contract(s) or a put option contract(s)? Why?

b.What does it cost (in USD) to hedge the entire crop?

c.What is the net revenue from selling the entire crop, after considering the option premium, if the spot price of corn is USD 4.50 per bushel in December?

d.What is the net revenue from selling the entire crop, after considering the option premium, if the spot price of corn is USD 3.70 per tonne in December?

Answer 1

a) Since the crop has to be sold, West Ridge Farms should buy put options. Put option allows the buyer to sell the product at a given strike price.

b) Option cost for 1 Bushel = $0.20

For 75,000 Bushels, cost = 75,000 * $0.20 = $15,000

c)

If the price is $4.50, the West Ridge Farms would not enforce Put contract as it is for only $4.00 Bushel.

Hence selling price = $4.50 * 75,000 = $337,500

Minus option cost = $15,000

=$322,500

d)

Put contract would be enforced and the option would yield $4.00 per Bushel.

Hence total inflow = $4.00 * 75,000 = $300,000

Minus option costs = $300,000 - $15,000 = $285,000