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Question - Your company, Highly Frosted Corn Flakes Inc. has placed an order with Sweetums Sugar Inc. for 2,016,000 pounds of refined sugar to be delivered in 4 months at the market price (spot price) at the time of delivery. Your company is concerned that the price of refined sugar may be very high in 4 months and would like to hedge this risk using sugar forwards. The standard contract size for forward contract on refined sugar is 112,000 pounds. The current spot price of refined sugar is $0.10 /lb. and the current 4-month forward price is $0.12 /lb.
1. How would you hedge your company's position? Answer the question specifying whether you would take a long or a short potion in forward contracts on refined sugar and the number of contracts that you take a position in.
2. Assuming that the refined sugar contract is settled only with physical delivery at the end of the 4-month period, explain the exact steps at the end of 4 months that you would go through starting with taking delivery of refined sugar from Sweetums and settling the forward contract with physical delivery and spot market transactions if the spot price of refined sugar turns out to be $0.15 in 4 months. What is the final net cost of refined sugar to your company?
3. Now answer (b) assuming that the forward contract is cash-settled i.e. that physical delivery does not take place. What is the final net cost of refined sugar to your company?
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