Question13 A cattle farmer expects to sell 500 cattle in 4 months and fears prices will fall. According to the futures hedging decision rule, she should: Enter a long forward contract with a bank today to lock in a guaranteed purchase price for the cattle she owns Sell (short) cattle futures today, because she intends to sell cattle and currently holds a long position in the physical commodity Buy a call option on cattle futures today to retain the right to benefit if cattle prices unexpectedly rise Buy (long) cattle futures today to hedge against rising feed and input costs that could erode her profit margin ResetMaximum marks: 1 Flag question undefined

Question

BlackTom AI · Accepted Answer

Producers who will sell a commodity in the future typically take a short futures position to protect against falling prices.

Relevant knowledge points and concepts:
- Hedging vs. speculation: hedging reduces price risk; speculation seeks profit from price moves.
- Short hedge (selling futures): a producer holding the physical commodity (a long spot position) sells futures to offset future spot-price risk.
- Offset mechanism: losses on the physical sale when spot falls are offset by gains on the short futures position (and vice versa), subject to basis risk (difference between spot and futures at settlement).

Step-by-step reasoning:
1. The farmer expects to sell 500 cattle in 4 months — she currently has an effective long position in cattle (she owns the cattle).
2. If cattle prices fall by the sale date, her revenue from selling the cattle will decline; she wants to lock in a selling price today.
3. By selling (going short) cattle futures now for delivery around the same time she will sell the cattle, she creates a position that gains when spot falls, offsetting the loss on the physical sale.
4. If prices rise, she will receive a higher spot price when selling cattle but incur a loss on the short futures position; net result approximates the locked-in price (ignoring basis changes).

Illustrative numbers:
- Suppose current futures = $100/head. She shorts futures for 500 cattle.
- If in 4 months spot = $90, she loses $10/head on the physical sale (100 → 90) = −$5,000 total, but gains $10/head on the short futures = +$5,000. Net ≈ $0 from price movement, effectively locking in ~$100/head.
- If spot = $110, she gains $10/head on physical sale but loses $10/head on futures; net again ≈ locked price.

Why the correct answer is correct:
- Selling (short) cattle futures hedges the farmer’s exposure as a future seller; it directly offsets adverse price declines.

Why other choices are incorrect:
- Enter a long forward contract to lock in a purchase price: a long forward commits to buy, not sell; the farmer wants to lock a selling price (would need to short a forward).
- Buy a call option: gives the right to buy (benefit from price rises); a producer worried about falling prices would buy a put to insure a minimum sale price, not a call.
- Buy (long) cattle futures: this hedges against rising prices (useful for buyers of cattle or rising input costs), not for a seller.

Conclusion: The correct action is to sell (short) cattle futures today. This matches the provided answer: "Sell (short) cattle futures today, because she intends to sell cattle and currently holds a long position in the physical commodity."

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