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An industrial-level farmer based in Asia produces a crop that is sold on the world markets. Because

Questions and AnswersPosted On:2023-07-31 22:35:43Viewed:110

An industrial-level farmer based in Asia produces a crop that is sold on the world markets. Because the
farmer is a small producer relative to global output, he cannot affect the crop’s price and is therefore a
price-taker. On the world markets, the crop’s price is denominated in USD. More so, the farmer expects
the crop’s price to decline significantly by next season’s harvest.

 

The farmer has some knowledge of financial economics, and three ideas come to mind:
i) He thinks about short-selling equity in companies that also produce this commodity,
ii) He considers purchasing put options on this commodity, and
iii) He considers writing (i.e., creating) a call option on this commodity.
Which of these strategies would you recommend? Your advice should be logical, coherent, and very
specific. You should clearly identify the risk-return trade-offs of the strategy and specify under what
conditions, if any, your advice is conditional on. Your answer should be between 2-4 paragraphs. A
paragraph is normally 4-6 sentences and deals with a specific idea or theme. You may also use graphs,
diagrams and algebra if desired


Best Answer

expert

expert

Solved by verified expert

Last updated on:2023-07-31 22:35:43

Recommended Strategy

Given the farmer's situation and expectations, the most suitable strategy would be ii) Purchasing put options on this commodity. This strategy allows the farmer to hedge against the risk of the crop's price falling, as he expects. A put option gives the holder the right, but not the obligation, to sell a commodity at a specified price (the strike price) within a certain period. If the crop's price does fall, the farmer can exercise the option and sell the crop at the higher strike price, thus mitigating his losses.

Risk-Return Trade-Offs
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In conclusion, while all three strategies have their merits and risks, purchasing put options is the most suitable for this farmer given his expectations and circumstances.


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