Hedging and long-Term Supply Contracts.
Consider a breakfast cereal company that will make and sell $10.0(H).000 of cereal next year.
It's only cost is that it must buy 200,000 bushels of wheat to make that cereal.
The market price per bushel of wheat next year. P. is unknown; the company faces the risk that wheat prices will be high. (Wheat cannot be stored, so you can't buy the wheat this year and store it to use next year.)
Buying in advance. Assume that the company has the ability to precommit this year to buy bushels of wheat next year at a price of $100. Let C represent the number of bushels the company precommits to buy in advance; the company needs 200,000 bushels in total, so any of the bushels not bought in advance must be bought at price of wheat next year, P.
i. Please write down the company's profit next year as a function of the number of bushels the company precommits to buy in advance (C) and the price of wheat next year (P). (profit = $4,000,000 +200 x P - C x $50 is an example of a wrong answer written in the right way)
ii. What C should the company choose if it wishes to eliminate all wheat price risk?