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# Futures Contracts

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1. A farmer anticipates having 50,000 bushels of wheat ready for harvest in September. What would be the implications of hedging by (a) selling 8 contracts (b) selling 10 contracts, and (c) selling 12 contracts of September wheat?

2. A soybean processor intends to acquire 350,000 bushels of beans in July, process them into meal and oil, and sell these products in August. Conversion ratios are as follows:
1 bushel beans = 50 lb meal
9 lb oil
1 lb water

Put on a crush indicating the profit margin and the number of contracts to buy and sell. Prices are as follows:

July beans = \$5.9275/bushel
August oil = \$0.2121/lb
August meal = \$247.80/ton

3. What is basis? Explain the difference between "normal backwardation" and "contango."

4. What is the meaning of "marked-to-market"? What is the difference between open interest and volume of trade?

#### Solution Preview

1. A farmer anticipates having 50,000 bushels of wheat ready for harvest in September. What would be the implications of hedging by (a) selling 8 contracts (b) selling 10 contracts, and (c) selling 12 contracts of September wheat?

Size of contracts (CBOT)
1 contract= 5,000 bushels

For 50,000 bushels, number of contracts required for hedging= 10 =50,000 / 5,000

(a) selling 8 contracts
With 8 contracts 40,000 bushels are hedged =5,000 x 8
Remaining 10,000 bushels are not hedged
Therefore, there is a speculative cash postion for 10,000 bushels
Thus there is under-hedging

(b) selling 10 contracts

With 10 contracts 50,000 bushels are hedged =5,000 x 10
Since, the cash position is for 50,000 bushels
The entire cash position is hedged

(c) selling 12 contracts

With 12 contracts 60,000 bushels are accounted for =5,000 x 12
Since, the cash position is for 50,000 bushels
There is overhedging
Therefore, there is a speculative future postion for 10,000 bushels

2 A soybean processor intends to acquire 350,000 bushels of beans in July, process them into meal and oil, and sell these products in August. Conversion ratios are as follows:
1 bushel beans = 50 lb meal
9 lb oil
1 lb water

Put on a crush indicating the profit margin and the number of contracts to buy and sell. Prices are as follows:

July beans = \$5.9275 /bushel
August oil = \$0.2121 /lb
August meal = \$247.80 /ton

Size of contracts (CBOT)

Soybeans: 5,000 bushels
Soybeans oil: 60,000 lbs
Soybeans meal: 100 short tons

Soybeans:
Amount of soybean to be procured= 350,000
Therefore, number of contracts required= 70 contracts =350,000 / 5,000

Soybeans oil:
1 bushel of soybeans= 9 lb oil
Thereofre, 350,000 bushel of soybeans= 3,150,000 lb oil =350,000 x 9
60,000 lbs of oil = 1 contract
Therefore, 3,150,000 lbs of oil = 52.50 contract =3,150,000 / 60,000

Soybeans meal:
1 bushel of soybeans= 50 lb meal
Thereofre, 350,000 bushel of ...

#### Solution Summary

Answers to questions on Futures related to Hedging, crush, basis, normal backwardation,, contango, marked-to-market, open interest, volume of trade etc.

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## Future contracts : margin account, theoretical future price for the contract, hedging price risk using futures, future contract to reduce beta of an investment. Options- put, theoretical value, Black model to compute the value of the call option

1. The CBOT offers a mini Dow Jones future contract. The multiplier on the contract is 10. The initial margin is \$6,000; maintenance margin is \$2,500. As of the close of trading Monday, February 18 the June contract was priced at 12358. You can find quotes at the Wall Street Journal's Market Data Center. Assume that on Monday the 21st you take a short position in one contract (at the closing price). You deposit \$6,000 margin.

A. Record settlement prices for trading on Tuesday - Friday (February 19-22).
B. Construct a table showing charges and credits to the margin account.
C. At what price will (or did) a margin call occur?

2. The DJIA closed on February 18 at 12348.21. The September 2008 future contract (214 days) was priced at 12366. Continuously compounded interest rates are 4%.

A. Assuming the contract is correctly priced compute the dividend yield for the DJIA.
B. Now assume that the dividend yield is 3%. Compute the correct price for the contract.
C. Given your answer in B describe an arbitrage strategy you could profit from given that the future is priced at 12500. Describe all transactions. How much profit would you earn?

3. The spot price of 40,000 pounds of live-cattle is \$35,000. You are interested in an August 2008 (6 months) cattle forward contract. The cost of caring for cattle between now and August 2008 is \$6000. This amount would be paid in three equal installments in February 2008, May 2008 2007 and August 2008. Interest rates are 6%.

A. Compute the theoretical future price for the contract.
B. You take a long position in the contract at the price computed in part A. What is the value of the forward contract when you enter it? In April 2008 cattle forwards are selling for \$47,000.Compute the value of your contract.

4. Today the spot price of Brazilian coffee is \$1.07/ pound. The December 2008 future is priced at 117.50 cents per pound. Each contract is for 40,000 pounds. You are a coffee grower and expect to have 120,000 pounds of coffee ready for delivery in December 2008.
A. Describe the position you should take in the futures market to hedge your price risk.
B. You enter into the position described in (A). Three months from now (in May) you sell your coffee in the spot market and close your future position. At this time
(December) the spot price of coffee is \$1.15 per pound and the future is priced at \$1.19. Compute the effective price per pound you receive for your coffee.

5. A shirt manufacturer would like to hedge against an increase in the price of materials. She finds that cotton futures have an 85% correlation with her raw material costs. The price of cotton futures has a standard deviation of 15 cents; her raw material costs have a standard deviation of 20 cents. She anticipated purchasing 500,000 pounds of material in September 2008. Cotton futures contracts are for 50,000 pounds.
A. What position should the shirt manufacturer take in the futures market (Long/short and number of contracts)?
B. Has she eliminated price risk? Briefly explain.

6. You have \$2 million of retirement savings. Your funds are invested in a mutual fund with a beta of .7.
A. You are worried about a market correction so you would like to reduce your beta to 0 between now and June by using the future contract from Problem #1. Should you take a long or a short position? How many contracts should you use?
B. Assume you take the position described in A. In June the DJIA has increased to
12600. Your portfolio has increased in value to \$2.1 million. How close did you come to the desired result?
C. Now assume that you feel the market will do well so you would like to increase your beta to 1.4. What position should you take in the June DJIA future?

7. The Dow Jones is currently listed at 12348.21. You find that a Put on a June 2008 futures contract (X = 12500) is selling for \$697. Interest rates are 4%. Compute the theoretical value of a June 2008 call with exercise price = 12500.

8. Use the Black model to compute the value of the call option priced in number 7. Volatility is 15%

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