Use of futures contracts to hedge cotton inventory—fair value hedge
On December 1, 2014, a cotton wholesaler purchases 7 million pounds of cotton inventory at an average cost of 75 cents per pound. To protect the inventory from a possible decline in cotton prices, the company sells cotton futures contracts for 7 million pounds at 66 cents a pound for delivery on June 1, 2015, to coincide with its expected physical sale of its cotton inventory. The company designates the hedge as a fair value hedge (i.e., the company is hedging changes in the inventory's fair value, not changes in cash flows from anticipated sales). The cotton spot price on December 1 is 74 cents per pound.
On December 31, 2014, the company's fiscal year-end, the June cotton futures price has fallen to 56 cents a pound, and the spot price has fallen to 65 cents a pound. On June 1, 2015, the company closes out its futures contracts by entering into an offsetting contract in which it agrees to buy June 2015 cotton futures contracts at 47 cents a pound, the spot rate on that date. Finally, the company sells its cotton for $0.47 per pound on June 1, 2015.
Following are futures and spot prices for the relevant dates:
DateSpotFuturesDecember 1, 201474¢66¢December 31, 201465¢56¢June 1, 201547¢n/a
Recently Asked Questions
- Determine the internal rate of return for a project that costs $167,000 and would yield after-tax cash flows of $20,000 per year for the first 5 years, $28,000
- Since 1991, all of the following have weakened the Commonwealth of Independent States, EXCEPT: options: Ukraine's departure. Eastern Europe's expansion under
- How would I figure out ï»¿ triangle ï»¿ ABC, <C is the right angle, and explain how to get the remaining sides and angles by rounding to the nearest