Imagine a baker who has the opportunity to bid on a contract to supply a local military base with bread for an entire year. The problem is the baker must commit to a price today and hold to that price for the entire year. Identify the risk faced by the baker, and explain how the use of a futures contract could transfer the risk.

Question

What will be an ideal response?

Answer 1

The baker faces the problem of not knowing what the future price of flour (wheat) will be. He may feel quite comfortable developing a price for the bread based on the current prices of wheat, but if the price of wheat should increase the bread making profits will fall and may turn into significant losses. Without the ability to transfer this risk the baker would probably have to pass on this opportunity. Fortunately the baker could purchase a wheat futures contract that would expire in a year, giving him the right to purchase some quantity of wheat at a price reflecting today's market price. If the market price of wheat increases he will lose on the baking operation but the value of his futures contract will increase. If the price of wheat falls, his futures contract loses value but his baking profits will increase.