Question

Lucas owns a large farming operation which encompasses over 5,000 acres of corn. The crop this year is abundant and will be ready for harvesting next month. Lucas likes the market prices today but expects the prices to decline over the next month as the supply of corn increases.

a.) Explain Hedging using Lucas' case including the purpose of the hedging and the impact of this hedging position when the market price next month goes up or goes down.

Answer 1

Lucas would want to sell at the best price possible. Since he anticipates the price of corn to fall, he is likely to have a loss by the time the crop is harvested. Corn producers can hedge against falling corn price by taking up a position in the corn futures market. He can take a short hedge to lock the future selling prices of the corn. By entering into a future contract, Lucas can hedge his risk of falling prices. This means that he will be given the contract or the strike price for the corn despite the future market price. If the prices increase, still Lucas will be in a profitable position since even though his futures position loses, the cash position gains.