A wheat flour manufacturer is wanting to hedge commodity price risk - namely the wheat price. They want to protect against any unfavourable move in the wheat price and want to fully participate in any favourable movements. A ? on wheat would suit the manufacturer, however, the ? on wheat would result in a higher upfront premium cost to the manufacturer but provide slightly better protection. Alternatively, if the manufacturer desired a reduction in any hedging cost, and was willing to forgo some part of a favourable price move in the grain price, but still remain protected against an unfavourable price move, they could establish a hedge comprised of a long ? wheat ? and a short ?.
Question
A wheat flour manufacturer is wanting to hedge commodity price risk - namely the wheat price. They want to protect against any unfavourable move in the wheat price and want to fully participate in any favourable movements. A ? on wheat would suit the manufacturer, however, the ? on wheat would result in a higher upfront premium cost to the manufacturer but provide slightly better protection. Alternatively, if the manufacturer desired a reduction in any hedging cost, and was willing to forgo some part of a favourable price move in the grain price, but still remain protected against an unfavourable price move, they could establish a hedge comprised of a long ? wheat ? and a short ?.
Solution
A long put option on wheat would suit the manufacturer. This would give them the right to sell wheat at a predetermined price, protecting them from any unfavorable price drops. However, the long put option on wheat would result in a higher upfront premium cost to the manufacturer but provide slightly better protection.
Alternatively, if the manufacturer desired a reduction in any hedging cost, and was willing to forgo some part of a favorable price move in the grain price, but still remain protected against an unfavorable price move, they could establish a hedge comprised of a long out-of-the-money put option on wheat and a short out-of-the-money call option on wheat. This strategy is known as a collar.
The long out-of-the-money put option would protect against significant price drops, while the short out-of-the-money call option would offset the cost of the put but would limit the benefit from favorable price increases.
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