You are the finance manager of Oman Flour Mills. Oman flour mills imports 600 tons of wheat from Australia per month. The mill uses the wheat for production of bread. On 1" April spot price of Australian wheat is 1200 S per ton. The finance manager is worried that by end of April spot price of Australian wheat will rise to 2000 $ per ton.
To protect the company against the sharp rise in input cost of wheat, on 1" April the finance manager purchased 600 wheat futures contracts for end of April expiry (30 April expiry) from Chicago Commodities Exchange at price of 1250 per ton. The finance manager feels that by end of April price of Chicago wheat futures will rise to 2050 per ton. The finance manager is interested in hedging
and not speculation.
The problem is that Chicago wheat is not suitable for Oman Flour Mills for production of bread. Even if Oman Flour Mills takes delivery of the wheat from Chicago Commodities Exchange, it will not be
able to use it.
Why did the finance manager book Chicago wheat futures. Explain with calculations
The finance manager booked Chicago wheat futures as a form of hedging to protect the company against the sharp rise in the input cost of wheat. By purchasing the wheat futures contracts at a price of $1250 per ton, the company is locked in to pay that price regardless of any potential increase in the spot price of Australian wheat.
Here's how the calculation works:
Without Hedging:
- Spot price of Australian wheat: $1200 per ton
- Potential spot price by end of April: $2000 per ton
- Increase in cost per ton: $2000 - $1200 = $800
With Hedging:
- Purchase price of Chicago wheat futures: $1250 per ton
- Potential future price by end of April: $2050 per ton
- Increase in cost per ton: $2050 - $1250 = $800
By booking the Chicago wheat futures, the finance manager is able to effectively lock in a price for wheat and protect the company from potential price increases. While the company may not be able to use the Chicago wheat for production of bread, the primary goal is to hedge against the risk of rising input costs for wheat.