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You are a distributor of gold and need to make deliveries of 10,000 kilogram (kg) one month from now
You are a distributor of gold and need to make deliveries of 10,000 kilogram (kg) one month from now. You currently have no gold in inventory. The current spot price of wheat is $8 per kg and the futures price for delivery in one month is $8.2. You would like to hedge the uncertainty about the spot price one month from now. i) If your storage cost is $0.15 per kg (paid at the end of month), what would you do? (assume the monthly compound interest rate is r) (3 marks) ii) Suppose that in the short run, your storage cost increases to $0.25 per kg. What would you do? (assume the monthly compound interest rate is r) (3 marks)
Expert Solution
According to cost of carry model the price of futures of a commodity is
F = Spot price + Storage cost saved + convenience yield + interest cost saved
i) Given that the current price of futures is 8.2
And the spot price is 8 per kg
Future price = 8 + 0.15( Storage cost)
F = 8.15
Since the futures are over valued we will sell future and buy stock and net gain is
-8(Spot price) - 0.15(Storage cost) + 8.2 ( Gain on futures)
= 0.05 ( Arbitrage gain)
ii) Here theoretical F should be
F = 8 + 0.25 = 8.25
Actual F is 8.2
Here Futures are undervalued we will buy stock and sell futures
+8(Spot price) + 0.25(Storage cost saved ) - 8.2 ( cost on futures)
= 0.05( aribtrage gain)
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