Reference no: EM131449652

Financial Futures and Options

A key use of futures contracts is hedging. In this assignment, you will complete five hedging questions. The problems including hedging: (1) agricultural commodities; (2) non-agricultural commodities; (3) exchange rates; (4) indexes; and (5) interest rates.

Q1.  You are an agricultural market consultant for a Midwestern cooperative in Randall, Iowa.  The cooperative purchases corn from local farmers, stores the corn during the course of the year, and then sells it to large corn processors like ADM and Cargill who use the corn to produce corn syrup, cattle feed, and ethanol.

The cooperative's manager informs you that they have made agreements to sell 5,000,000 bushels of corn to their buyers in February for $4.10 per bushel.  They have open agreements to purchase corn from local farmers on the spot market in November at spot market price.  The cooperative's cost of carry is $0.15 per bushel per month.  The cooperative's manager is concerned that the price of new-harvest corn may increase, thus increasing the cooperatives cost of purchasing corn in November and reducing their profits from their agreement with the corn processors.  He asks you to help direct the cooperative's hedging efforts.  

It is currently April and cash corn prices are at $3.50 per bushel.  Historically, the cash price for corn sold in November in Randall, Iowa has been $0.05 below the nearby futures price.

(a) What should the cooperative manager do in the futures market to hedge the cooperative's corn purchases that they will make in November? (Position, contract, number of contracts)

(b) What is the manager's "expected hedge price?"  That is, what price does the manager expect to have to pay for corn purchased in November given the cooperative hedges its future purchases? 

It is now November and the cooperative manager is ready to purchase corn from local farmers.  The new-harvest cash corn price is now $3.95 per bushel.  The nearby futures contract is trading at $4.02.

(c) What is the realized hedge price (the price that the cooperative had to pay for the corn after accounting for gains or losses in the futures market)?

(d) Was the cooperatives expected hedge price equal to their realized hedge price?  If not, why?

(e) Will the cooperative make money on their marketing strategy (forward contracting corn sales to large agribusinesses in February and using futures to hedge corn purchases in November)?  How much will they make or lose?  What would have happened had they chosen not to hedge their corn purchases?

Q2. New Mexico State University uses natural gas for steam-producing boilers and the gas-fired cogeneration turbine at the central utility plant.  The facility manager is concerned that the price of natural gas, which has been at historical lows over the last ten years, will increase over the summer months, substantially increasing the University's fuel costs when they purchase gas at the beginning of the winter.  The management team would like to hedge their projected winter natural gas use (250,000 mmBtu) using futures contracts.

Today the natural gas spot market is trading at 2.980 per mmBtu. November natural gas futures are trading at $3.338 per mmBtu. Based on prices observed over the last three years management expects that spot prices will be $0.30 over futures in November when the University purchases its natural gas for the winter.  One futures contract represents 10,000 mmBtu.         

(a) What should the management team do in the futures market in order to fully hedge their price risk (position and number of contracts)? Why?

(b) When the management team makes its monthly report to the University president, what price should they tell the president the University should expect to pay for natural gas this coming winter?  That is, what is NMSU's expected hedge price?

In November, when the management team is ready to purchase natural gas for the upcoming winter, natural gas is trading for $3.20 per mmBtu in the spot market.  Nov '17 futures are trading at $2.75 per mmBtu.

(c) What price was management team able to obtain given that they chose to hedge in the futures market?  That is, what is NMSU's realized hedge price?

(d) When the president learns of the realized price obtained by the management team he questions their actions indicating that they have misled him - The price you received net of your actions in the futures market is not equal to the price you "quoted" him prior to the hedge.  What should the management team say to the president?

(e) After you calm the president down in part (d) he complains that you should not have hedge in the futures market because you would have been better off simply purchasing gas in the spot market.  What do you say to him?      

Q3. Fresh Squeezed Oranges, LLC (FSO) purchases oranges from agricultural producers in Florida and California and processes them into frozen concentrated orange juice (FCOJ).  FSO's management has ordered four specialized packaging machines from an Italian manufacturer.  The packaging machines will be delivered to FSO's Florida production plant in three months, at which time FSO will have to pay the manufacture 2 million euros.  While the dollar has been relatively strong against the euro over the last several years, the dollar has been weakening over the last several months and FSO's management is concerned that the weakening trend may continue, increasing the cost of the new equipment in dollar terms.  Currently the spot exchange rate between the euro and the dollar is 1.0868 (it takes 1.0868 dollars to purchase one euro).  Three-month out Euro/dollar futures are trading at 1.0940.  One euro/dollar futures contract contains 125,000 euros.

(a) If FSO's management purchased the packaging machine today how much would they have to pay in dollars?

(b) What should FSO's management do in the futures market in order to hedge their exchange rate risk? (position, number of contracts) Why?

(c) If the board of directors asks FSO's management what they might expect to pay for the 2 million euros they will have to buy in three months, what should management's response be?

Three months elapse, the packaging machines have been delivered and FSO's management must pay the Italian equipment manufacturer.  The spot exchange rate has risen to 1.1514 and euro/dollar futures are trading at 1.1558.

(d) If FSO's management had not hedged in the futures market how much would they have to pay the Italian equipment manufacturer?

(e) How much did FSO have to pay for the equipment given that they hedged in the futures market?

 (f) What is FSO's effective (realized) exchange rate given that they chose to hedge in the futures market?  Show answer out to 4 decimal places.  

Q4. A non-profit foundation has a portfolio heavily weighted in stocks valued at $5,000,000.  The foundation's director is concerned about potential short-term (three-month) declines in the foundation's portfolio that may occur due to a variety of contemporary issues, e.g., political changes.    

The portfolio is constructed such that it is has an effective beta of 1.40 (compared to the S&P 500).  The foundation's director would like to reduce portfolio's short term risk entirely such that they portfolio will neither gain nor lose money over the next three months.  The future's exchange trades a mini S&P 500 index that has a size equal to $50 per index point.  The S&P 500 is currently trading at 2,104 in the spot market and the futures (three months out) are trading at 2,095. 

(a) What should the foundation's director do in the futures market in order to temporarily hedge their position?

Over time the director's concerns were realized as the S&P 500 falls points.  The S&P 500 (spot market) is now trading at 1,999.  Futures are trading at 1,997.

(b) In percentage terms how much did the market fall (as measured by the spot S&P 500 index)?

(c) In percentage terms how much did the foundation's portfolio fall (without futures hedging) assuming the portfolio's reported beta is accurate?

(d) If the director had not chosen to adjust the fund's beta what would the foundation's fund be worth now?

(e) What is the portfolio worth given that the director chose to hedge?

(f) How much did the portfolio decrease (in percentage terms) given that the foundation used futures?  Did the strategy work?  How do you know?

Q5. On March 20 a company treasurer realizes that on June 18 the company will have to issue $10 million of commercial paper with a maturity of 180 days to fund purchases of inventories needed to meet upcoming orders in the last quarter of the year.  If the paper were issued today the company would receive $9,756,000 and would have to pay back $10 million after the 180 day period.  June Eurodollar futures are trading at an index of index is quoted as 95.80.

(a) What interest rate is associated with the company's paper issuance?  Assume discrete semiannual compounding).

(b) What should the company do in the futures market in order to hedge their risk?  (position and number of contracts).

On June 18 the company is issues its commercial paper.  It can now receive $9,803,500 for its commercial paper issuance.  The September Eurodollar futures index is quoted as 96.80.

(c) Relative to the spot interest rate what has happened to interest rates between March 20 and June 18 faced by the company?

(d) If the company had not hedge what interest rate would the face on June 18?

(e) How much did the company make or lose in the futures market?

(f) What is the effective or realized interest rate paid by the company (rate when gains or losses in the futures market are included in the interest rate calculation)?

Attachment:- Assignment Files.rar