John Carter: Hedging
3 Pages Posted: 21 Oct 2008
A farmer can lock in the prices of his product and wants to know how much, if any, of the production should be hedged. This case examines how the answer is affected by factors such as the certainty of how much will be produced, the relationship between prices and production, and the risk aversion of the farmer. This case permits an analysis of how hedging policies should change reflecting the different behavior of the variables that affect the results.
JOHN CARTER: HEDGING
John Carter was a farmer in Northern Massachusetts. John, like all of the farmers around him, grew apples and shipped his harvest to Boston for sale at the prevailing market price. The farm had been in John's family for three generations; from his inheritance and prudent management, John had built his net worth to $ 300,000. Like many of his neighbors, John was being pressed by increasing costs and by the failure of revenues to keep up with this increase. John worried that a really bad year could wipe him out and he might lose the farm.
John tried to project the amount of harvest and the price that it would bring at market. This year he believed the farm would earn revenues in the vicinity of $ 310,000. John's analysis of past costs indicated that the farm would incur $ 220,000 this year in fixed costs and that variable costs would be $ .03 per pound of apples produced. The tax schedule for farmers meant that John did not pay any taxes unless he earned over $ 25,000 in a year. Between $ 25,000 and $ 50,000, he would have to pay a marginal rate of 24 percent, so that his actual taxes on $ 50,000 would be 12 percent. Over $ 50,000, the marginal tax rate increased to 45.6 percent on earnings.
During the past few years, John had hedged his revenues using forward contracts. When he entered a forward contract, John had to guarantee the delivery of the contracted amount of apples at harvest. If John's own crop fell below the amount of apples that he had sold forward, he would have to buy enough apples on the open market to make up the difference. Any apples that John's farm produced above the amount specified in the contract would be sold at the prevailing market price. All transactions, including any payment received by John from the forward contract and any selling or buying of apples on the spot market at harvest would be settled at the same time in the fall.
John believed the price at harvest would best be approximated by a normal distribution with a mean of 20.79 cents per pound and a standard deviation of 2.47 cents per pound. Forward contracts were only available in increments of 100 tons, and the current forward rate was $ .2079 per pound. In the past, John had assumed that he could predict with certainty what
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Keywords: hedging, risk managment, risk profile
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