Suppose the current spot price of wheat is $25 a bushel. A wheat farmer expects to produce 1,000 bushels at the end of the season, and she wants to ensure that she gets at least $19 a bushel. If a put option on 1,000 bushels of wheat with a strike price of $20,000 and an expiration date at the end of the season is selling for $1,000, the farmer can purchase the put option to guarantee she gets $19 a bushel.

Question

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By purchasing the put option, the wheat farmer can exercise the option at the end of the season to sell 1,000 bushels of wheat at the strike price of $20 a bushel for a guaranteed minimum income of $19,000 ($19 x 1,000). The cost of the put option is $1,000, which is the premium paid for the right to exercise the option. Therefore, the farmer can ensure a minimum price of $19 a bushel for her wheat and protect herself against potential decreases in the spot price of wheat.

Suppose the Current Spot Price of Wheat Is $25 a Bushel