Question

ABC Company is a chocolate producer. It purchases cocoa to make their chocolate. It plans to use 2,000 pounds of cocoa over the next 9 months, and it’s concerned with the price increase of cocoa. So the company decides to go long in a forward contract with a price specified as $10 per pound on for 2,000 pounds to be delivered in September 2020. a) Develop a profit and loss table at future prices of $8, $9 and $11, $12. b) What’s the forward contract loss when cocoa price declines to $9 in September 2020? c) What’s the cocoa cost saving when cocoa price declines to $9 in September 2020? d) Explains the benefit of going with a long position for the company.

Answer 1

Here the company has obligation to purchase 2000 ponds of cocoa within next 9 months. it is afraid of the price increase of cocoa and decided to hedge by using a forward contract @ $10/pound.

A) The profit and loss is calculated s follows.

Forward rate	future prices	calculation of profit / loss
$10	$8	loss = 2000*(10-8)= $4000
$10	$9	loss= 2000*(10-9)= $2000
$10	$11	profit= 2000*(11-10)=$2000
$10	$12	profit= 2000*(12-10)= $4000

B) Forward contract loss when cocoa price declines to $9 in September 2020 = 2000*(10-9)= $2000

C) They can save $2000 on price decline, but since the Forward contract is taken there is loss and no savings.

D) Since the company has liability to purchase cocoa it has to pay $ for purchasing, which they are expecting to rise in future. so they can take a long position and today itself and make benefit out of the expected price increase.benefit means savings of the purchase cost of cocoa.