The Farmer and the Baker The forward contracts always specify the minimum deliverable quality,and often a formula for delivering other qualities A market in forward contracts may be devised that encourages cash settlement,and discourages physical delivery THE COURSE OF FINANCE 2017 SPRING SJTU 11
The Farmer and the Baker The forward contracts always specify the minimum deliverable quality, and often a formula for delivering other qualities A market in forward contracts may be devised that encourages cash settlement, and discourages physical delivery THE COURSE OF FINANCE 2017 SPRING SJTU 11
The Farmer and the Baker Jamela sells forward 200,000b for 1-month delivery 2.00 bushel .This short has no monetary value at this time A month later,the spot price of deliverable wheat is $2.20 b,and the forward is about to expire,and so is also trading at $2.20 b The contract now has a monetary value.The long position is worth S(2.20-2.00)/bushel .Jamela settles her position by paying $20,000 THE COURSE OF FINANCE 2017SPRING SJTU 12
The Farmer and the Baker ³Jamela sells forward 200,000b for 1-month delivery @ 2.00 / bushel ®This short has no monetary value at this time ³A month later, the spot price of deliverable wheat is $2.20 / b, and the forward is about to expire, and so is also trading at $2.20 / b ³The contract now has a monetary value. The long position is worth $(2.20 - 2.00) / bushel ®Jamela settles her position by paying $20,000 THE COURSE OF FINANCE 2017 SPRING SJTU 12
The Farmer and the Baker Jamela has made a loss of S20,000 on her trade in the hypothetical wheat forwards market She recovers this loss when she sells her wheat This is a true hedge.She has lost the opportunity to participate in a rise in the price of wheat in return for down-side protection Not protecting the up-side risk exposure THE COURSE OF FINANCE 2017 SPRING SJTU 13
The Farmer and the Baker Jamela has made a loss of $20,000 on her trade in the hypothetical wheat forwards market She recovers this loss when she sells her wheat This is a true hedge. She has lost the opportunity to participate in a rise in the price of wheat in return for down-side protection Not protecting the up-side risk exposure THE COURSE OF FINANCE 2017 SPRING SJTU 13
The Farmer and the Baker The baker's hedge in the forward market resulted in a settlement of S20,000 When he takes physical delivery,he exactly offsets higher spot prices with this $20,000 He traded the opportunity of lower wheat prices for a known price Both gained!Mohammed's gain (at Jamela expense)is 20/20 hindsight, and should be irrelevant to both of them THE COURSE OF FINANCE 2017 SPRING SJTU 14
The Farmer and the Baker The baker’s hedge in the forward market resulted in a settlement of $20,000 When he takes physical delivery, he exactly offsets higher spot prices with this $20,000 He traded the opportunity of lower wheat prices for a known price Both gained! Mohammed’s gain (at Jamela expense) is 20/20 hindsight, and should be irrelevant to both of them THE COURSE OF FINANCE 2017 SPRING SJTU 14
The Farmer and the Baker Omar is rich,and wants to get richer He purchases forward 100,000b of wheat@ S2.00/bushel,for delivery in 1-month At maturity,deliverable wheat costs $2.20/b and he makes a cash settlement,gaining S20,000 Omar is a speculator profiting from his purported(claimed)understanding of the market THE COURSE OF FINANCE 2017 SPRING SJTU 15
The Farmer and the Baker Omar is rich, and wants to get richer He purchases forward 100,000b of wheat @ $2.00/bushel, for delivery in 1-month At maturity, deliverable wheat costs $2.20/b and he makes a cash settlement, gaining $20,000 Omar is a speculator profiting from his purported(claimed) understanding of the market THE COURSE OF FINANCE 2017 SPRING SJTU 15