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Your assignment is to prepare and submit a paper on hedging oil consumption. There are other inherent risks associated with business such as currency fluctuations, volatility of crude oil prices and s
Your assignment is to prepare and submit a paper on hedging oil consumption. There are other inherent risks associated with business such as currency fluctuations, volatility of crude oil prices and so on. In order to reduce exposure to volatility in the market, many participants prefer hedging strategies using derivatives. A derivative is a financial instrument which derives its value from the underlying asset. One of the hedging strategies alternatives that are available to the market participants is by using futures derivative. The main purpose of futures markets is to minimise uncertainty in transactions and hence reduce risk. The basic objective of futures market is to hedge the associated risk by taking such a position so as to neutralize possibility of risk as far practicable. A futures contact is a standard contract between two market participants to buy or sell a specific asset of standard quality, quantity for a given price agreed upon on the date of contract (also known as strike price) with payment and delivery occurring at maturity date. The contracts are standard in the sense that quantity, quality, price, strike price, delivery date, initial margin, marking to market, etc. are done via intermediary and not directly negotiated between parties involved in transaction. Hence, the refinery may enter into futures contract with its customers giving them the opportunity to purchase oil at current prices at a later date in future. In this way even if the prices of oil rises in future, the refinery would not require to pass on the higher costs to their customers (CME, 2006, pp.49-53). After discussing the concept of futures, it is now important to illustrate how futures might help the US Gulf refinery to hedge risk. There are two different methods of hedging namely short hedge and long hedge. A short hedge is suitable when the hedger owns the asset (as in this case) and expects it to sell at some time in future. Thus, the oil refinery may take short position in futures contract. A long hedge on the other hand involves taking the long position (buy at later date). This strategy is suitable when the hedger (in this case customer) knows that it will have to purchase a particular asset in future but would like to purchase at current price. In both the strategies payment and deliver occurs at maturity of contact which is usually three months. To further illustrate these strategies in details, consider the following example: Assuming that on June 13 (present) the oil refinery has taken a short position by negotiating a contract to sell 1 million barrels of crude oil. It is also agreed that the price applicable in the contract will be on the market price of September 13. So, for each 1% rise, the producer will gain $10,000 and similarly for each 1% decline in price refinery will lose $10,000. The standard futures contract on CME platform is 1,000 US barrels (or 42,000 gallons), hence the company can hedge exposure by shorting 1,000 September futures contracts. If the last trading close price was $90 per barrel, strike price is $85 and assuming that price per barrel in September is actually $80, then per barrel gain of the oil refinery would be $5 (since, $85 - $80). This means the total gains for entire contract would be $5000 ($5 x 1000).