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A wheat farmer expects to harvest 260,000 bushels of wheat in September. In order to pay for the seed and equipment the farmer had to withdraw $150,000 from his savings account on January 1 of this year. He earns 4.8% interest on the savings account and interest on the account accrues monthly in arrears. The farmer is worried about fluctuation in the wheat price and wishes to hedge the position. Wheat futures are currently quoted as follows:

September: 341 cents/bushel

December: 355.5 cents/bushel

The prices quoted are in cents per bushel and wheat futures contracts are per 5000 bushels.

a.) Construct the perfect hedge for the farmer using futures contract. How many contracts does he need to buy or sell?

b.) What is the effective price he receives for the wheat if there is basis risk? The December Futures price is 348 in September.

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