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Lecture28-2004 - Lecture XXVIII Introduction to Options and...

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1 Lecture XXVIII Introduction to Options and Futures I. Futures and the hedge A. Most undergraduate courses on agricultural marketing include a section on futures markets and hedging. However, to discuss options and option pricing, we will briefly introduce the use of option markets. B. Futures markets such as the Chicago Board of Trade allow for the trading (purchase and sale) of commodities to be delivered at some future data. On November 18, 2004 the future price for December 2004 corn was 204’0. 1. From a risk management standpoint farmers/decision makers could choose to forward market cattle in November on August 2, 2004. 2. Forward marketing using futures markets is typically referred to as hedging. To forward market cattle on August 2, 2004 for sale on November 18, 2004 the farmer would sell a contract of fat cattle on August 2. Referring to Table 1, the price of fat cattle in the August 2 for January-February delivery is $89.62/cwt. Table 1. Futures Prices for Fat Cattle Date Open High Low Close 11/17/2004 88.05 89.10 87.95 88.90 8/2/2004 89.30 90.02 89.25 89.62 6/17/2004 88.45 88.75 88.15 88.60 Transactions Cash Price 85.44Sell on 8/2 89.62 Buy on 11/17 88.90 Gain 0.72 Net Price 86.16 3. When the farmer markets cattle on November 18, 2004 he receives $85.44/cwt on the cash market. 4. In addition, he has gained $0.72/cwt on the futures market (the price that he buys back the futures contract for is $88.90/cwt). 5. If the farmer had attempted to market his cattle on June 17, 2004 instead the farmer would loose $0.30/cwt on each contract resulting in a $85.14/cwt price.
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