Question

In six months, a cereal company plans to sell 10,000 boxes of “Corn Crisps” for $2.00 per box and will need to buy 5,000 bushels of corn to do so. In doing so, it also incurs non-corn costs of $1,000. The current spot price of corn is $3.50 per bushel, and the effective six-month interest rate is 6 percent. The company will hedge by purchasing call options at $0.47 with a strike price of $3.50 per bushel. What total profit would the company earn if the market price of corn in six months is $2.90, $3.30, $3.70, and $4.10, respectively?

Answer 1

The top line of the company is given at = 10000 boxes * 2 per box = $ 20000

Cost are : Non corn cost = $ 1000 and corn cost = 5000 bushels * cost per bushel

Cost per bushel will be a function of option pay off and market price of corn in 6 months:

The call option pay off will be = Max (Market price after 6 months - strike price - premium, - premium)

The pay off per bushel from the call option and net cost & profit for the company will be as below:

Note the following:

• Net cost per bushel is expiry price plus the pay off from the call option and as we can see that irrespective of the expiry price the company is hedged by capping its max price at strike price plus premium paid which is $ 3.97 per bushel
• Company profit is 20000-cost of 5000 bushels - 1000 (non corn cost)