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Unformatted text preview: UNIVERSITY OF ESSEX DEPARTMENT OF ECONOMICS EC372 Economics of Bond and Derivatives Markets Short Hedging Example of risky hedging (i.e., realistic, imperfect hedging) In February (today) a farmer, A , plans to sell 50,000 bushels of wheat in November, after the next harvest. The price at which A will sell the wheat is not known today. A seeks to reduce uncertainty about the price of wheat in November by adopting a hedge strategy in February. The chosen hedge instrument is the wheat futures contract on the CBOT. The farmer knows that the wheat he will produce is not suitable for delivery to satisfy the CBOT contract. However, he has evidence that the futures contract price for the CBOT contract is correlated (albeit not perfectly) with the spot price of wheat. Consequently, A sells wheat futures contracts for December delivery (the nearest contract month after the wheat is to be sold). Suppose the futures contract price today for December delivery is $10 per bushel (i.e., $50,000 per contract because each contract is for 5,000 bushels). In November, A takes two actions: (1) sell the wheat in the spot market, and (2) offset the futures contracts (buy the same number as were sold in February). CASE (A): Suppose the wheat price falls to a low level in November (e.g., as a result of a bumper harvest). The farmer sells the 50,000 bushels of wheat in the spot market for, say, $6 per bushel. At the same time he buys futures contracts (i.e., offsets those sold in February) for, say, $7 per bushel a profit of $3 per bushel (i.e., $15,000 per contract). The profit on the futures contracts helps to compensate forper bushel (i....
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- Spring '12