Hedging Practice Questions:

1. You are a coffee exporter. Prices have been falling in the spot market. Should you sell
immediately or use a futures contract? Explain your choice.

Since prices are falling, we should sell coffee futures now (take a short position).
This locks in today’s higher price for future delivery, protecting us if prices continue
to decline. Selling immediately could also work, but if we still hold physical stock or
expect to sell later, using a futures hedge allows us to wait while securing current
price levels.

2. A steel importer notices that iron ore prices on the LME are rising. What can they do
today to protect against higher costs next month?

We should buy iron ore futures today. By taking a long position, we lock in the current lower
price for next month’s delivery. If market prices rise, the gain from the futures position will
offset the higher spot cost we face when buying the actual iron ore.

3. You see that Brent crude prices on ICE are $80 today but expected to reach $95 in three
months. How could an airline hedge fuel expenses?

We can buy Brent crude or jet-fuel futures to secure the current $80 price level. If prices rise to
$95, our gain on the futures will offset the higher cost of physical fuel purchases. Alternatively,
buying call options on fuel would protect us while keeping the flexibility to benefit if prices fall.

4. A wheat trader buys in the spot market at $230/ton but fears price drops before
reselling. What hedge could limit losses?

We should sell wheat futures. This short hedge ensures that if prices fall, the profit from our
futures position compensates for the loss in the physical market, limiting the overall downside
risk.

5. Compare: If a company needs copper in six months, is a spot or futures purchase more
suitable? Why?

A futures purchase is more suitable. Buying spot would require paying and storing the copper
now. A long futures position allows us to secure today’s price for delivery in six months,
protecting against future price increases while keeping our cash free.
 6. A palm-oil exporter and a buyer agree to deliver 500 MT in three months at today’s
price. What kind of contract is this — and what is its main risk?

This is a forward contract, a private agreement between two parties for a

future delivery at a fixed price. The main risk is counterparty risk one party
may fail to fulfill the contract since there’s no central exchange guaranteeing
performance.

7. A sugar trader wants flexibility to cancel a deal if prices fall. Should they use
a forward or option contract? Why?

We should use an option contract, specifically a put option. It gives us the

right, but not the obligation, to sell at a fixed price. If prices fall, we can
exercise the option; if prices rise, we can let it expire and sell in the open
market. A forward contract would force us to sell even if market prices
improved.

8. You are a rice importer. Futures prices are higher than spot. Should you still hedge
using futures? What’s the trade-off?

We can still hedge using futures, but we must accept a trade-off. The higher futures price
(known as contango) means paying more now for price protection. The benefit is certainty and
protection against sharp price spikes; the cost is potentially paying above the future spot price if
prices remain stable or drop.

9. A jet-fuel buyer uses futures to lock in price. When market prices later drop, what
happens to their hedge?

If market prices drop, we will lose on the futures contract since we locked in a higher price.
However, we will gain from buying cheaper fuel in the spot market. The two outcomes offset
each other, stabilizing our total cost. The hedge removes uncertainty, even if it doesn’t maximize
profit.

10. Two cocoa traders both hedge using forward contracts — one defaults. What lesson does
this teach about counterparty risk?

This demonstrates the importance of counterparty risk. Forward contracts

depend on the trustworthiness of the parties involved, since there’s no
clearinghouse. The lesson is to assess credit risk carefully or use exchange-
traded futures, which guarantee performance and reduce the risk of
default.

11. A flour mill expects wheat prices to rise but wants protection if they fall. Which type
of option (call or put) should they buy, and why?

We should buy a call option on wheat. This gives us the right to purchase
wheat at a fixed price if market prices rise, preventing higher costs. If prices
fall, we can ignore the option and buy cheaper wheat in the open market. It
offers both protection and flexibility.

12. If the premium on an option is expensive, what factors should a company consider before
paying for it?

Futures or forwards may be cheaper if we don’t need flexibility.

Essentially, we must decide if the “insurance” provided by the option justifies
its price.

13. A gold refiner buys a call option for delivery in three months. The market price falls
below the strike price — should they exercise it? Explain.

No, we should not exercise the option. If the market price is below the strike,
we can buy gold more cheaply on the open market. We would let the option
expire and lose only the premium we paid, which is the cost of having the
protection.

14. Why might a company choose options instead of futures, even though options cost more
upfront?

We might prefer options because they provide flexibility. They protect us if prices move against
us but still allow us to benefit from favorable movements. Futures lock in both upside and
downside outcomes, while options limit our loss to the premium paid.

15. A Yemeni importer buys palm oil priced in USD. The Yemeni Rial weakens sharply
before payment. What hedging tool could protect them?

We can use a forward exchange contract to lock in the USD/YER rate today,
protecting against future depreciation of the Rial. Alternatively, a call option
on USD could also hedge this risk while keeping flexibility if the exchange
rate later moves in our favor.
 16. A Malaysian exporter selling in USD expects the ringgit to strengthen. How can they
hedge the currency risk?

If the ringgit strengthens, we’ll receive fewer ringgit when converting USD
earnings. To hedge, we can sell USD forward locking in today’s stronger rate.
This ensures our future dollar receipts maintain their value when exchanged
for ringgit.

17. What is the difference between using a forward exchange contract and a currency
option to manage FX exposure?

A forward exchange contract fixes the rate and commits both sides to the deal, eliminating both
risk and opportunity.
A currency option gives us the right but not obligation to exchange at a fixed rate, allowing us to
benefit if market movements turn favorable, though we pay a premium for this flexibility.

18. A company exporting to Europe uses both euro and dollar invoices. How does this help
reduce currency-risk concentration?

By invoicing in both euros and dollars, we diversify our currency exposure. If

one currency weakens, the other may strengthen, balancing the impact on
our revenues. This acts as a natural hedge, reducing dependence on any
single currency’s fluctuations.

19. Fuel prices are rising rapidly. Using Ryanair’s case (from the class video), explain how
early fuel hedging protected profits.

Ryanair locked in low fuel prices early through futures and options. When
global oil prices later surged, competitors faced soaring costs, but Ryanair’s
expenses stayed stable. This strategy protected their profit margins and
gave them a major competitive advantage during price shocks.

20. Imagine you are managing an edible-oil importing company. Prices are volatile due to
war in a supplier country.
 Which tool (futures, forwards, or options) would you choose and why?
 Futures if an exchange-traded market exists — transparent and low
default risk.

 Forwards if we need customized delivery terms.

 Options if we want flexibility to benefit if prices later fall.

 What risks would remain even after hedging?

  Political and supply disruptions, which financial contracts can’t fix.

  Credit or counterparty risk (especially in forwards).
  Currency risk, if the contract is in USD and our local currency fluctuates.