A small soybean farmer wants to hedge the price risk of his next crop, but he is financially constrained. He can't raise capital by either borrowing money or selling his current assets. Instead, he sells call options on his soybean crop with a strike price of $14 per bushel at a premium of $0.50 a bushel. Using the process from selling the call options, he buys put options on his soybean crop with a strike price of $11.00 per bushel at a premium of $0.35 per bushel. The risk-free interest rate is 0 per cent. By taking these derivative positions, the farmer has guaranteed that he will earn somewhere between $14.15 and $11.15 per bushel.

Question

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By selling call options at a strike price of $14 and buying put options at a strike price of $11, the farmer has established a price range of $14.15 to $11.15 per bushel, which provides him with a guaranteed minimum and maximum price for his crop. The premiums earned from selling the call options and paying for the put options will offset each other to some extent but may not entirely cancel out. However, the net cost of the options will be lower than the capital required for a futures contract or other hedging strategies, which makes this approach attractive for financially constrained farmers.

A Small Soybean Farmer Wants to Hedge the Price Risk