Suppose that standard deviation of monthly changes in spot prices of live cattle is 1.2 cents per pound of live cattle, and the standard deviation of monthly changes in futures prices or the closing contracts is 1.4 cents per pound of live cattle. The coefficient of correlation between the two changes is 0.8. If a food processing company wants to hedge 500,000 pounds of live cattle and the size of the relevant futures contract on live cattle is 45,000 pounds then (1) What strategy should a beef producer (user of live cattle) follow? What does it mean? (2) What is the optimal number of futures contract with no tailing of the hedge? (3) What is the optimal number of future contract with tailing of the hedge?

Suppose that standard deviation of monthly changes in spot prices of live cattle is 1.2 cents per pound of live cattle, and the standard deviation of monthly changes in futures prices or the closing contracts is 1.4 cents per pound of live cattle. The coefficient of correlation between the two changes is 0.8. If a food processing company wants to hedge 500,000 pounds of live cattle and the size of the relevant futures contract on live cattle is 45,000 pounds then (1) What strategy should a beef producer (user of live cattle) follow? What does it mean? (2) What is the optimal number of futures contract with no tailing of the hedge? (3) What is the optimal number of future contract with tailing of the hedge?

International Financial Management

14th Edition

ISBN:9780357130698

Author:Madura

Publisher:Madura

Chapter11: Managing Transaction Exposure

Section: Chapter Questions

Problem 35QA

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The standard deviation of monthly changes in the spot price of live cattle is (in cents per pound) 1.5. The standard deviation of monthly changes in the futures price of live cattle for the closest contract is 2. The correlation between the futures price changes and the spot price changes is 0.5. It is now October 15. A beef producer is committed to purchasing 500000 pounds of live cattle on November 15. The producer wants to use the December live-cattle futures contracts to hedge its risk. Each contract is for the delivery of 40000 pounds of cattle. What strategy should the beef producer follow?
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This is a follow up question so I copied/pasted the same question below for your convenience: An investor enters into a long futures position to buy 5,000 bushels of wheat for 575 cents per bushel. The initial margin is $5,000 and the maintenance margin is $2,500. c. Starting from the original position, the investor would have to see a price movement of _____ cents (above/below) ______ 575 cents in order to withdraw $2,000 from the margin account. So Initial Margin = $5,000;Maintenance Margin = $2,500;Withdraw Amount = $2,000;Original Price per Bushel = 575 cents or $5.75;Number of Bushels = 5,0001. How did you come up with the calculation? You wrote that: (new_price * 5000)/(5.75 * 5000) = withdraw amount/mainenance margin 2. Could you please explain the right side (i.e., why the ratio is withdraw amount to mainenance margin)?