Explanation:
The farmer needs to be short the futures contracts. The two sources of basis risk confronting the farmer will result from the fact that he is using a cattle contract to offset the price movement of his buffalo herd. Cattle prices and buffalo prices may not be perfectly positively correlated. As a result, the correlation between buffalo and cattle prices will have an impact on the basis of the cattle futures contract and spot buffalo meat. The delivery date is a problem in this situation, because the farmer's hedge horizon is winter, which probably will not commence until December or January. In order to maintain a hedge during this period, the farmer will have to enter into another futures contract, which will introduce an additional source of basis risk.
(Book 3, Module 34.1, LO 34.c)
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Question 20
A buffalo farmer is concerned that the price he can get for his buffalo herd will be less than he had forecasted. To protect himself from price declines, the farmer has decided to hedge with live cattle futures. Specifically, he has entered into the appropriate number of cattle futures positions for September delivery that he believes will help offset any buffalo price declines during the winter slaughter season. The appropriate position and the likely sources of basis risk in the hedge are, respectively:
A
short; choice of futures delivery date.
B
short; choice of futures asset.
C
short; choice of futures delivery date and asset.
D
long; choice of futures delivery date and asset.
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