Question

Bakers use wheat as an input to make flour. A bakery anticipates needing? 100,000bu of wheat in 3 months. It is worried that the price of wheat might rise. What position should it take in the wheat futures contract to hedge the price? risk?

Answer 1

To protect against rising wheat prices, the bakery should take a long position in wheat futures. This hedging strategy ensures that the bakery pays a fixed price for wheat, thus avoiding the risk of price inflation for their required quantity.

Step-by-step explanation:

To hedge against the potential rise in wheat prices, the bakery should take a long position in wheat futures contracts. By doing so, the bakery locks in the current price, ensuring that they will pay a set price for wheat in three months, regardless of market fluctuations. This approach helps minimize the bakery’s risk of price volatility and provides cost certainty for their required 100,000 bushels (bu) of wheat. In the event that the price of wheat increases, the bakery is protected because they have a contract to purchase at the lower, predetermined price. If the price of wheat decreases, the bakery will still have to buy at the higher contract price, but the cost of securing price certainty typically outweighs the potential for savings from a price drop.

Understanding the relationship between supply and demand is crucial when dealing with commodities like wheat. Substitute goods, market equilibrium, and price expectations all play a significant role in determining the demand and pricing of wheat flour. For instance, if the price of corn flour, a substitute, rises, the demand for wheat flour would increase, and vice versa.