You have been requested by the secretary of agriculture of a Central American country to determine whether cattle produced in that country could be hedged using the Chicago Mercantile Exchange(CME) live cattle contract. What information would you need to collect to determine whether this is feasible? What suggestions would you propose (to the country, to the CME) to make hedging Central American cattle in the CME cattle contract?

Answer explained below

Explanation:

The variation between the futures or derivatives price and spot price at any given point in time is called basis. It is obtained by subtracting  future price from the cash price and can be negative or positive.

Whatever be the basis position, whether positive or negative, before expiry of the contract but at the end of the expiry, it will converge with the spot prices.

Basis risk is the probability of the basis strengthening or weakening after the hedge has been implemented till the time the hedge is exited. Basis can fluctuate making calculation of hedging difficult.

Long basis positions gains from a strengthening of a basis. Short hedges have long basis positions. Short hedge means taking up a short futures position where underlying is owned for delivery in the future.

Short basis points gains from weakening of the basis. Long hedges have a short basis points. Long hedges involve buying up of futures and if underlying prices increase the gain in the long future, will be there.

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