Deck 4: Introduction to Risk Management

Question 1

Which of the following situations does NOT describe someone who should implement a hedge strategy?

A) Mary is very nervous about losing profits if selling prices drop
B) Melanie's creditors will not lend her money if her crops might lose money
C) Katherine's board of directors will not tolerate losses, even if it means profits are smaller
D) Dawn wants to reduce price fluctuations, but will need to conduct many transactions to achieve her goals

Answer 1

D

Question 2

A farmer sells 4 million bushels of corn at a spot price of $2.10 per bushel.The total cost of production was $9.2 million.The farmer has an effective tax rate of 25%.If the farmer entered into a futures contract at a price of $2.40 per bushel on 4 million bushels,what is the farmer's net loss or gain?

A) $100,000 loss
B) $800,000 loss
C) $300,000 gain
D) $400,000 gain

Answer 2

C

Question 3

Why are synthetics created and/or calculated when the actual derivative is available?

Answer 3

The pricing of a synthetic may reveal an arbitrage opportunity,or at least a cheaper method,by which to employ the desired strategy.

Question 4

Why would a manufacturer elect to use a long call strategy instead of a forward contract to hedge the risk associated with variable costs?

Question 5

A 6-month forward contract for corn exists with a price of $1.70 per bushel.If Farmer Jayne decides to hedge her 20,000 bushels of corn with the forward contract,what is her profit or loss if spot prices are $1.65 or $1.80 when she sells her crop in 6 months? Her total costs are $33,000.

A) $1,000 gain or $1,000 loss
B) $0 gain or $3,000 gain
C) $0 loss or $3,000 loss
D) $1,000 gain or $1,000 gain

Question 6

Corn call options with a $1.75 strike price are trading for a $0.14 premium.Farmer Jayne decides to hedge her 20,000 bushels of corn by selling short call options.Six-month interest rates are 4.0% and she plans to close her position in 6 months.What is the total premium she will earn on her short position?

A) $2,800
B) $2,912
C) $800
D) $1,600

Question 7

Given a 25% chance of a 600,000 bushel yield and a 75% chance of a 500,000 bushel yield,what quantity should the farmer hedge in order to protect against an uncertain harvest? Assume the farmer is willing to take reasonable risk.

A) 0
B) 500,000
C) 525,000
D) 600,000

Question 8

When selecting among various put options with different strike prices,in order to hedge a long asset position,which of the following statements is true?

A) Higher strike puts cost more and provide higher floors
B) Higher strike puts cost less and provide higher floors
C) Lower strike puts cost more and provide higher floors
D) Lower strike puts cost less and provide higher floors

Question 9

A $1.75 strike call option has a $0.14 premium.The $1.75 strike put option premium is $0.12.What is the net cost for Farmer Jayne to create a synthetic short forward contract? (Assume 4.0% interest.)

A) $0.0208
B) -$0.0208
C) $0.000
D) -$0.0424

Question 10

Farmer Jayne decides to hedge 10,000 bushels of corn by purchasing put options with a strike price of $1.80.Six-month interest rates are 4.0% and the total premium on all puts is $1,200.If her total costs are $1.65 per bushel,what is her marginal change in profits if the spot price of corn drops from $1.80 to $1.75 by the time she sells her crop in 6 months?

A) $248 loss
B) $0
C) $252 gain
D) $1,500 loss

Question 11

Farmer Jayne bought a $1.70 strike put option for $0.11 and sold a $1.75 strike call option for a premium of $0.14.Her total costs are $1.65 per bushel and interest rates are 4.0% over this period.What is the floor in her strategy assuming a 20,000-bushel crop?

A) $624
B) $1,624
C) $2,624
D) $3,624

Question 12

KidCo Cereal Company sells "Sugar Corns" for $2.50 per box.The company will need to buy 20,000 bushels of corn in 6 months to produce 40,000 boxes of cereal.Non-corn costs total $60,000.What is the company's profit if they purchase call options at $0.12 per bushel with a strike price of $1.60? Assume the 6-month interest rate is 4.0% and the spot price in 6 months is $1.65 per bushel.

A) $6,504 profit
B) $8,005 loss
C) $12,064 profit
D) $11,293 loss

Question 13

To plant and harvest 20,000 bushels of corn,Farmer Jayne incurs fixed and variable costs totaling $33,000.The current spot price of corn is $1.80 per bushel.What is the profit or loss if the spot price is $1.90 per bushel when she harvests and sells her corn?

A) $3,000 gain
B) $3,000 loss
C) $5,000 gain
D) $5,000 loss

Question 14

Why are managerial controls over option and forward trading departments vital to proper risk control?

Question 15

A farmer expects to harvest 800,000 bushels of corn.To eliminate price risk,the farmer elects to short corn futures.What would cause the farmer to short only 720,000 bushels of corn?

A) Basis risk
B) Illiquid futures markets
C) Margin requirements
D) Quantity uncertain

Question 16

KidCo bought forward contracts on 20,000 bushels of corn at $1.65 per bushel.Corporate tax rates are 35.00%.Revenue is $100,000 and other costs are $60,000.Spot prices on corn are $1.75 per bushel.Calculate the after-tax net income.

A) $7,000 loss
B) $7,000 gain
C) $4,550 loss
D) $4,550 gain

Question 17

Corn call options with a $1.70 strike price are trading for a $0.15 premium.Farmer Jayne decides to hedge her 20,000 bushels of corn by selling short call options.Six-month interest rates are 4.0% and she plans to close her position and sell her corn in 6 months.What is her profit or loss if spot prices are $1.60 per bushel when she closes her position?

A) $1,000 loss
B) $2,000 gain
C) $2,120 loss
D) $2,120 gain

Question 18

Explain the relationship between options costs and profits under a put option insurance strategy.

Question 19

Two 6-month corn put options are available.The strike prices are $1.80 and $1.75 with premiums of $0.14 and $0.12,respectively.Total costs are $1.65 per bushel and 6-month interest rates are 4.0%.Farmer Jayne wishes to hedge 20,000 bushels for 6 months.What is the highest profit or minimum loss between the two options if the spot price in 6 months is $1.70 per bushel?

A) $88 loss
B) $88 gain
C) $496 loss
D) $496 gain

Question 20

From a strictly conceptual perspective,why would any manufacturer consider hedging their variable costs? Answer as if you own the company.

Question 21

Engage the class in a discussion of why firms hedge risks.Steer them towards an understanding that firms manufacture products,they do not speculate in commodity markets.Now,turn the tables and ask why manufacturers do not employ pure hedge strategies with forward contracts.Try to get the class to arrive at the conclusion that since firms are experts in their respective industries,their knowledge may benefit them by implementing creative strategies,while still hedging losses.