Question

Hanson’s financial forecast is estimating this year’s revenue to be $40 million. Holden Tank’s Board of Directors are concerned that this year’s corn prices will fall significantly. They wish to use the agricultural options market3 to provide insurance against falling corn prices reducing revenue. How can they do this and how many options should be used?

Answer 1

Holden Tank can use put options as insurance against falling corn prices by buying a number of options equivalent to their estimated corn production. The options serve as a risk management tool, guaranteeing a minimum price for their crop.

Step-by-step explanation:

Holden Tank can use agricultural options to hedge against the risk of falling corn prices. They would accomplish this by purchasing put options for corn, which give them the right to sell corn at a set price, known as the strike price, within a specific time frame. In order to calculate how many options Holden Tank should purchase, they will need to estimate their expected corn production in bushels and then buy an equivalent number of options contracts, as each contract covers a specific number of bushels.

Using agricultural options is a form of insurance because it allows farmers to lock in a minimum price for their crop. If the market price of corn falls below the strike price, the value of the options will increase, compensating for the drop in crop revenue. However, if the market price remains stable or increases, the options will expire worthless, but the crop can be sold at the market price, ensuring no loss is incurred from purchasing the options.