Maximum Buying Price - using calls as insurance against rising prices Bill is an
ID: 2799188 • Letter: M
Question
Maximum Buying Price - using calls as insurance against rising prices Bill is an Illinois hog producer. Since corn is a major input factor for hog production, its price determines whether Bill will make a profit or loss on his hogs. Knowing his costs pretty well, Bill thinks that he’ll generate positive net returns if he can buy corn for no more than USD 3.50/bu for his next run (group) of hogs. It is January 5, and Bill’s hogs will go on feed (i.e., start to be fed) on February 15. Bill knows that he can obtain insurance against rising corn prices using the options market, but he is not sure how exactly this works. His friend told him that in order to get protection against rising prices he needs to have calls on the March corn futures contract. But does Bill need to buy or sell those options? What strike price does he pick? And will that really work? Bill is uncertain. Can you help him? On January 5, March corn calls trade at different strikes and premiums. Based on the information below, compute for each option the maximum buying price that Bill will have to pay for his corn. Assume that basis is usually USD -0.20 on the March futures on February 15, interest costs are USD 0.01, and commission is USD 0.02. Strike Premium 3.25 3.40 3.55 3.80 3.95 0.43 0.26 0.18 0.13 0.07 Indicate the option that you would recommend to Bill! Explain to Bill why this option is better than the others. Does he need to buy or sell this option to get the desired price protection? Show the cash flows and the net price that Bill will have to pay for his corn on February 15 for the following scenarios Cash corn is at USD 3.91/bu on February 15, March corn futures trade at USD 4.12/bu, and the time value of the call on the March futures is zero. Cash corn is at USD 3.11/bu on February 15, March corn futures trade at USD 3.29/bu, and the time value of the call on the March futures is USD 0.01/bu. Interpret the results! What happens in each of the cases? Did Bill really get price protection?
Explanation / Answer
Today : Jan, 05
Date the Corn is required : Feb, 15
Q1. But does Bill need to buy or sell those options?
Ans. Bill need to buy a call option. In call option if the cost of corn goes above the strike price of the call option then he can excerise the call option and thereby protect against price rise. If the cost of the corn goes below the strike price of the call option then he can let the option expire and his loss will be miniminised to the premium paid or the cost of the call option.
Q2. What strike price does he pick?
The different Call Options Available are.
1. Strike Price = USD 3.25 & Option Premium = USD 0.43 Therefore if Bill wish to exercise this option the effective price at which he will be able to purchase corn will be USD 3.25 + USD 0.43 = USD 3.68. Hence Bill will not be able to use this option as the effective cost will be more than his acceptable cost i.e. USD 3.50/bu.
2. Strike Price = USD 3.40 & Option Premium = USD 0.26 Therefore if Bill wish to exercise this option the effective price at which he will be able to purchase corn will be USD 3.40 + USD 0.26 = USD 3.66. Hence Bill will not be able to use this option as the effective cost will be more than his acceptable cost i.e. USD 3.50/bu
3. The Strike Price of the other three Call Options are USD 3.55, 3.80 & 3.95 which is more than the acceptable cost of Bill i.e. USD 3.50/bu.
Hence bill will not be able to purchase any of the above mentioned Call Options.
Q3. Does he need to buy or sell this option to get the desired price protection?
Ans Bill will not be able to buy any of the above mentioned option. It is not profitable for Bill.
Q4.What happens in each of the cases?
Ans.
Case 1 Cash corn is at USD 3.91/bu on February 15, March corn futures trade at USD 4.12/bu, and the time value of the call on the March futures is zero. In this case Bill will not get any benefit.
Case 2 Cash corn is at USD 3.11/bu on February 15, March corn futures trade at USD 3.29/bu, and the time value of the call on the March futures is USD 0.01/bu. Hence the value of Call on the March Futures is USD 3.29/bu - USD 0.01/bu = USD 3.28/bu.
Q5. Did Bill really get price protection?
Ans Yes Bill really got protechtion on Cash corn transaction at USD 3.11/bu in Case2.