1. On Jan. 28, 2011, the February 2011 live cattle futures price was $ per hundredweight.

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1 Econ 339X Spring 2011 Homework Due 2/8/ points possible Short answer (two points each): 1. On Jan. 28, 2011, the February 2011 live cattle futures price was $ per hundredweight. If the cash price for live cattle was $ per hundredweight, what was the basis? -$ Each lean hog futures contract covers _40,000_ pounds. 3. Hedging: Holding _equal_ and _opposite_ positions in the cash and futures markets. 4. With a call option, the buyer pays the _premium_ and has the right, but not the obligation, to _buy_ a _futures_ contract at the _strike price_. 5. Given the futures and option prices in the table on the back, what was the intrinsic value of $14.00 put option for November 2011 soybeans? _77 cents per bushel_ Long answer (five points each, please show your work): 6. I am a speculator that went long on November 2011 soybeans on Jan. 24, Fill out the following table tracking my margin account. Even teachers make mistakes, below is the corrected answer for question 6. I forgot that the margin call brings the account back to the initial margin, not the maintenance margin. Date Gain/Loss Margin Call Account Balance 1/24/2011 $ $4, /25/2011 $ $1, $1, $4, /26/2011 $ $ $4, /27/2011 $ $87.50 $5, /28/2011 $ $ $4,900.50

2 For the following questions use the futures and options data on the back. Assume historical expected basis of -$0.25 per bushel and a commission of $0.01 per bushel for both crops. Explain your trade, show the math and draw the graph. 7. A speculator is eyeing the corn market. She wants to limit her risks, but believes that the Dec 2011 corn futures will trade below $4.50 before the crop is harvested. What should she do to profit from her belief? How far would prices have to fall for her to breakeven? Buy a put option on Dec corn a $4.50 strike price or higher. With a $4.50 put, the premium is cents and the commission is 1 cent. The put will start to pay off when the futures price falls below $4.50, but the speculator will not breakeven until the premium and commission are covered. That occurs at $4.3125, the strike price less the premium and commission. $ $ $0.01 = $ $1.40 $1.20 $1.00 $0.80 Net $0.60 $0.40 $0.20 $3.00 -$0.20 $5.00 $7.00 -$0.40

3 8. A speculator wants to limit his risk but is confident that prices will be volatile this year and expects prices to be below $5 and above $6 before harvest. What could he do to profit from price movement if he doesn t want to make margin calls? What will it cost him in premiums and what are his lower and upper breakeven prices? Buy a put option on Dec corn a $5.00 strike price and buy a call option on Dec corn a strike price. With a $5.00 put, the premium is cents and the commission is 1 cent. The put will start to pay off when the futures price falls below $5.00. With a call, the premium is cents and the commission is 1 cent. The call will start to pay off when the futures price rise above. For the combination, the speculator has spent $ on premiums and 2 cents on commission. The speculator will breakeven when the premium and commission are covered. Their lower breakeven price is $ $ $0.02 = $ Their higher breakeven price is + $ $0.02 = $ $1.50 $1.00 $0.50 $3.00 $5.00 $7.00 -$0.50 -$1.00 -$1.50 Put Call Net

4 9. A speculator is willing to take some risks and believes that the Dec 2011 corn contract will trade between $4.50 and $6.50 this year. What could he do that would provide him a profit from a stable market? If he is right about the trading range how much profit would he make? What are his risks and at what prices would he begin to lose money? Sell a put option on Dec corn a $4.50 strike price and sell a call option on Dec corn a $6.50 strike price. With a $4.50 put, the premium is cents and the commission is 1 cent. The put will start to pay out when the futures price falls below $5.00. With a $6.50 call, the premium is 50 cents and the commission is 1 cent. The call will start to pay out when the futures price rise above $6.50. For the combination, the speculator has received $ on premiums, but paid out 2 cents on commission. So the speculator initially makes $ If they are correct and prices stay between $4.50 and $6.50, they will keep the $ However, if prices go outside that range, they will have to pay on one of the options Their lower breakeven price is $ $ $0.02 = $ Their higher breakeven price is $ $ $0.02 = $ $1.00 $0.50 $3.00 $5.00 $7.00 -$0.50 -$1.00 -$1.50 Put Call Net

5 10. What could the speculator in #9 do if it looked like Dec 2011 futures prices were going to go above $6.50 to offset his risk? Buy back the $6.50 call (offsetting the position) or buy the underlying futures. 11. A hedger would like to buy a $5.00 put option on Dec corn? What is her expected minimum price? A $5.00 put option has a premium of cents and the commission is 1 cent. The expected basis is -25 cents. Expected minimum price = Strike price + basis - premium - commission = $ $0.25 $ $0.01 = $ $7.00 $5.00 $3.00 $1.00 $3.00 -$1.00 $5.00 $7.00 Put Cash Net

6 12. The same hedger decided what she really wanted is a floor price at $5.00 and the chance for higher prices if they occur. What is the least costly option strategy that will give her a $5.00 floor? How does it compare to a simple futures hedge at current futures prices? If prices stay the same or go lower what is the net price difference? At what futures price does the option provide a higher net price? Buy a $6.50 put. Expected minimum price = Strike price + basis - premium - commission = $ $ $ $0.01 = $5.01 $7.00 $5.00 $3.00 $1.00 $3.00 -$1.00 $5.00 $ Put Cash Net Futures hedge: sell Dec corn $5.765 Expected hedged price = Futures price + basis - commission = $ $ $0.01 = $5.505

7 $3.00 $5.00 $ Short Hedge Cash Net If prices stay the same or go lower, the hedge would have a 49.5 cent ($ $5.01) advantage. If prices move above $6.995, the put option will have the advantage. $7.00 $6.80 $6.60 $6.40 $6.20 $5.80 $5.60 $5.40 $5.20 $5.00 $3.00 $5.00 $7.00 Net from Put Net from Hedge

8 13. A soybean producer wants a net price above $12.00 per bushel. Show me a futures or option strategy that will achieve this goal? One strategy is to short hedge Nov soybean futures. Futures hedge: sell Nov corn $13.23 Expected hedged price = Futures price + basis - commission = $ $ $0.01 = $12.97 $16.00 $14.00 $12.00 $10.00 $ $12.00 $13.00 $14.00 $15.00 $ Short Hedge Cash Net

9 Another strategy is to buy a put option with a strike price at $14.40 or higher. Expected minimum price = Strike price + basis - premium - commission = $ $ $ $0.01 = $ $16.00 $14.00 $12.00 $10.00 $ $12.00 $13.00 $14.00 $15.00 $ Put Cash Net

10 14. A soybean processor is concerned about net prices above $ What are two strategies that the processor can do to protect against net cash prices above $14.00? One strategy is to long hedge Nov soybean futures. Futures hedge: buy Nov corn $13.23 Expected hedged price = Futures price + basis + commission = $ $ $0.01 = $12.99 $16.00 $14.00 $12.00 $10.00 Net $ $12.00 $13.00 $14.00 $15.00 $ Long Hedge Cash Net Remember the cash price is the cost to the processor, so we subtract the return from the long hedge from the cash price to get the net price.

11 Another strategy is to buy a call option with a strike price at $12.80 or lower. Expected maximum price = Strike price + basis + premium + commission = $ $ $ $0.01 = $ $16.00 $14.00 $12.00 $10.00 Net $ $12.00 $13.00 $14.00 $15.00 $ Call Cash Net Remember the cash price is the cost to the processor, so we subtract the return from the call option from the cash price to get the net price.

12 15. A soybean producer wants protection from falling prices and would like to take advantage of rising prices if they occur. What should she do? Provide an example. Buy a put option with a strike price near the futures price or higher. For example, at $ Expected minimum price = Strike price + basis - premium - commission = $ $ $ $0.01 = $ $16.00 $14.00 $12.00 $10.00 $ $12.00 $13.00 $14.00 $15.00 $16.00 Put Cash Net

13 16. The same soybean producer in #15 thinks that the price of protection from falling prices it too expensive and the floor is too low. If she is willing to give up some of the higher price potential what could she do? Provide an example and explain the trade-off. They could short hedge, but that would give up any high price potential. Futures hedge: sell Nov corn $13.23 Expected hedged price = Futures price + basis - commission = $ $ $0.01 = $12.97 $16.00 $14.00 $12.00 $10.00 $ $12.00 $13.00 $14.00 $15.00 $ Short Hedge Cash Net

14 Or they could offset part of the put option premium by selling an out-of-the-money call option. That effectively raises the expected minimum price by the call option premium less commission, but limits higher price potential at the call option strike price. Buy a put option with a strike price at $13.20 and sell a call option with a strike price at $ Expected minimum price = Put option strike price + basis - put option premium - put option commission + Call option premium - call option commission = $ $ $ $ $ $0.01 = $ $16.00 $14.00 $12.00 $10.00 $ $12.00 $13.00 $14.00 $15.00 $16.00 Put Call Cash Net

15 All prices and premiums are listed in dollars per bushel Dec Corn Nov Soybeans Strike Premium Opti Strike Premium Strike Premium Opti Strike Premium Price ons Price Price ons Price Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Put Call Call Call Call Call