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 proceeds 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 percent. By taking these derivative positions, the farmer has guaranteed that he will earn somewhere between $14.15 and $11.15 per bushel.

Question

Quizplus · Accepted Answer

By selling call options with a strike price of $14 and buying put options with a strike price of $11, the farmer has established a price range of $11.15 to $14.15 per bushel. The premium received from selling the call options offsets the cost of buying the put options, so the farmer has effectively hedged his price risk without raising any capital or selling any assets.

A Small Soybean Farmer Wants to Hedge the Price Risk