Question

A company will buy 1200 units of a certain commodity in one year. It decides to hedge 70% of its exposure using futures contracts. Spot price and futures price are currently $110 and $95. The one year futures price of the commodity is $95. If the spot price and the futures price in one year turn out to be $119 and $114, respectively. What is the average price paid for the commodity?

Answer 1

Answer: The average price paid for the commodity is $102.20

We follow these steps to arrive at the answer:

The company needs 1200 units in one year's time

It has hedged 70% of its requirement at a futures price of $95 per unit.

So, after one year, the company will buy
`840 units (1200 * 0.7)` at $95 per unit.

It still needs
`360 units (1200*0.3)` to meet its requirements. So, it will buy 360 units at the spot price prevailing after one year, i.e. $119.

We find the average price paid as follows:

`Average Price Paid = ((840 * 95) + (360*119))/(1200)`

`Average Price Paid = ((79800) + (42840))/(1200)`

`Average Price Paid = (122640)/(1200)`

`Average Price Paid = 102.2`