Question

Farmer Joe grows wheat and then sells it at the market price one year from now. His total costs are $5 per bushel of wheat. In one year, Grocer Bob buys wheat at the market price and then sells it for $15 per bushel of wheat. The one-year continuously compounded interest rate is 4%. For a strike price of $10, the call premium is $1 and the put premium is $0.50. For a strike price of $12, the call premium is $0.4 and the put premium is $1. Don’t forget that when your find profit in the following problems, you must add the profit from the hedging strategy to the unhedged profit of the firm.

a. What strategies can Grocer Bob use to hedge his profit?

b. Draw a profit diagram (1 year from now) for Farmer Joe if does not hedge.

c. Should Joe hedge using a long call or long put? ________________

i. Draw a profit diagram (1 year from now) for Farmer Joe if he purchases an option with strike price of $10.

Answer 1

a) Grocer bob can enter a call option (long call) to buy wheat at a specified price thereby locking in the purchase prices of the wheat.

b) Profit diagram for farmer Joe. Horizontal axis price after 1 year and vertical axis is Profit

c) Joe shall use long put to effectively lock in his selling price.

i)

Price	Option cost	Payoff	Effective selling price	Profit
5	0.5	5	10	4.5
6	0.5	4	10	4.5
7	0.5	3	10	4.5
8	0.5	2	10	4.5
9	0.5	1	10	4.5
10	0.5	0	10	4.5
11	0.5	0	11	5.5
12	0.5	0	12	6.5
13	0.5	0	13	7.5
14	0.5	0	14	8.5
15	0.5	0	15	9.5
16	0.5	0	16	10.5
17	0.5	0	17	11.5
18	0.5	0	18	12.5
19	0.5	0	19	13.5
20	0.5	0	20	14.5
21	0.5	0	21	15.5
22	0.5	0	22	16.5
23	0.5	0	23	17.5
24	0.5	0	24	18.5

answered by: anonymous