Reference no: EM133294459

Part I: Cattle Hedge 

A cattleman wants to hedge against possible low cattle prices to ensure an adequate profit margin. He plans to sell the cattle to the slaughterhouse in May. The cattleman's price objective is $1.25/lb, and he plans to sell 40,000 pounds of product. On January 20th he opens a position on the futures market using June Live Cattle contracts (size 40,000 lbs), that trade for $1.21 /lb.

1. What type of position should the cattleman open in the futures market? Is this a long or a short hedge? How would you calculate the actual selling/buying price for this hedge?

2. On May 20th, when the product is sold, the cattleman offsets his futures position at $1.15/lb. The (local) cash price is $0.05 above futures. Use a T-account to calculate the gains (losses) in both the cash and futures markets, the total profit/loss, the differences in the basis, and the actual selling price on May 20th.

3. Instead, assume that the cattleman's production was 44,000 pounds of product and that he used the same position as above to hedge his price risk. What would his hedge ratio be? What would the expected selling price be? Why?

Part II: Cocoa Hedge

Jershey, a chocolate candy manufacturer based in New Jersey, has decided to expand its production line. In order to launch their newest product in the market by January 20th (the "Super Sweet Valentine Chocolate Cuddle"), they need to purchases 100 (metric) tons of cocoa beans by January 5th. In order to protect against price increases, the company's buyer opened a futures position on October 1st using the March 2012 Cocoa futures (the contract size is 10 metric tons). The cost objective for every ton of cocoa beans was $2,500.

1. What is Jershey's position in the cash market? What position did they open in the futures market? How many contracts should they trade if they want to have a full hedge? What if they wanted a 0.5 hedge ratio?

2. On January 5th the price of the March Cocoa futures contract used for the hedge is $2,320/ton, and the cash price is $220/ton above futures. When the futures position was originally opened (October 1st) the price of the March 2011 contract was $1,990. Assume that the chocolate manufacturer fully hedges his position in the futures market (the hedge ratio is 1.0). Use a T-account to calculate the gains (losses) in both the cash and the futures market, total profits/losses, the differences in the basis, and the actual buying price on January 5th.

Now consider the case where the chocolate manufacturer decided to hedge only half of his cash position? Calculate the EHP and compare it with the above (Part II - 2). In which situation would he be better off? Why?