1. Lecture 4

2. Companies have risk Manufacturing Risk - variable costs Financial Risk - Interest rate changes Goal - Eliminate risk HOW? Hedging & Futures Contracts

3.  Kellogg’s produces cereal.  A major input and variable cost is sugar.  The price of a box of cereal is inflexible (i.e. it has an elastic demand function).  Kellogg’s is naturally “short” in sugar  “short” = a requirement to buy the commodity in the future. Profit Scenario for Kellogg’s Revenue  This is variable -costs  This is variable Profits

4. Asset Price Profit Loss To hedge their natural position, Kellogg’s will enter into a long futures / forward contract Short sugarLong Futures / Forward Contract Natural profit / loss position

5. Asset Price Profit Loss NET POSITION

6. Asset Price Profit Loss Farmer’s view Short Forward / futures Long sugar Profit Scenario for Farmer  This is variable Revenue  This is variable -costs Profits

7. Together Long Hedger Natural position: Short sugar Risk: Purchase price of sugar Hedge: Long contract Short Hedger Natural position: Long sugar Risk: Sales price of sugar Hedge: Short contract

8.  You are an Illinois farmer. You planted 100 acres of wheat this week, and plan on harvesting 20,000 bushels in March. If today’s futures wheat price is $1.56 per bushel, and you would like to lock in that price, what would you do?  Since you are long in Wheat, you will need to go short on March wheat. Since1 contract= 5,000 bushels, you should short four contracts today and close your position in March.

9.  In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price.  Show the transactions if the Sept spot price drops to $2.80. Revenue from Crop: 10,000 x 2.8028,000 June: Short 2K @ 2.94 = 29,400 Sept: Long 2K @ 2.80 = 28,000. Gain on Position------------------------------- 1,400 Total Revenue $ 29,400

10.  In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price.  Show the transactions if the Sept spot price rises to $3.05. Revenue from Crop: 10,000 x 3.0530,500 June: Short 2K @ 2.94 = 29,400 Sept: Long 2K @ 3.05 = 30,500. Gain on Position------------------------------- -1,100 Total Revenue $ 29,400

11. Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull 2007 2. 11 Time (a)(b) Futures Price Futures Price Spot Price Basis Risk = Spread between the Futures Price and Spot Price

12. Fundamentals of Futures and Options Markets, 6 th Edition, Copyright © John C. Hull 2007 3. 12 Time Spot Price Futures Price t1t1 t2t2 Basis Strengthens Spread between spot price and futures price gets smaller Basis Weakens Spread between spot price and futures price gets larger