Exhibit 4.1: Managing Financial risk Example 1 He would sell four contracts in May totaling 20.000 bushels in the futures market 20,000×$490=$98,000 In December he would buy four contracts to offset his futures position If the market price of corn drops to $4. 50 per bushel, cost is 20,000 X$4.50= 90,000 If the market price of corn increases to $5.00 per bushel, cost is 20,000 X $5.00=$100,000
Exhibit 4.1: Managing Financial Risk – Example 1 • He would sell four contracts in May totaling 20,000 bushels in the futures market. – 20,000 x $4.90 = $98,000 • In December, he would buy four contracts to offset his futures position. – If the market price of corn drops to $4.50 per bushel, cost is 20,000 x $4.50 = 90,000 – If the market price of corn increases to $5.00 per bushel, cost is 20,000 x $5.00 = $100,000
Exhibit 4.1: Managing Financial risk Example 1 Note: it doesn t matter whether the price of corn has increased or decreased by december If Price is $4.50 in December: Revenue from sale $90,000 Sale of four contracts at $4. 90 in May $98,000 Purchase of four contracts at $4.50 in December $90,000 Gain on futures transaction $8,000 Total revenue $98,000
Exhibit 4.1: Managing Financial Risk – Example 1 • Note: it doesn’t matter whether the price of corn has increased or decreased by December. If Price is $4.50 in December: Revenue from sale $90,000 Sale of four contracts at $4.90 in May $98,000 Purchase of four contracts at $4.50 in December $90,000 Gain on futures transaction $8,000 Total revenue $98,000
Exhibit 4.1: Managing Financial risk EXample 1 If Price is $5.00 in December: Revenue from sale $100,000 Sale of four contracts at $4.90 in May 98,000 Purchase of four contracts at $5.00 in December 100,000 Loss on futures transaction ($2,000) Total revenue $98,000 By using futures contracts and ignoring transaction costs he has locked in total revenue of $ 98,000
Exhibit 4.1: Managing Financial Risk – Example 1 • By using futures contracts and ignoring transaction costs, he has locked in total revenue of $98,000. If Price is $5.00 in December: Revenue from sale $100,000 Sale of four contracts at $4.90 in May $98,000 Purchase of four contracts at $5.00 in December $100,000 Loss on futures transaction ($2,000) Total revenue $98,000
Exhibit 4.1: Managing Financial risk Example 2 Options on stocks can be used to protect against adverse stock price movements A call option gives the owner the right to buy 100 shares of stock at a given price during a specified period A put option gives the owner the right to sell 100 shares of stock at a given price during a specified period One option strategy is to buy put options to protect against a decline in the price of stock that is already owned
Exhibit 4.1: Managing Financial Risk – Example 2 • Options on stocks can be used to protect against adverse stock price movements. – A call option gives the owner the right to buy 100 shares of stock at a given price during a specified period. – A put option gives the owner the right to sell 100 shares of stock at a given price during a specified period. • One option strategy is to buy put options to protect against a decline in the price of stock that is already owned
Exhibit 4.1: Managing Financial risk Example 2 Consider someone who owns 100 shares of a stock priced at $43 per share To reduce the risk of a price decline, he buys a put option with a strike(exercise) price of $40 If the price of the stock increases, he has lost the purchase price of the option(called the premium), but the stock price has increased
Exhibit 4.1: Managing Financial Risk – Example 2 • Consider someone who owns 100 shares of a stock priced at $43 per share. • To reduce the risk of a price decline, he buys a put option with a strike (exercise) price of $40. – If the price of the stock increases, he has lost the purchase price of the option (called the premium), but the stock price has increased