Casehero
Search case study...
J&L Railroad
Please scroll down to the bottom of this post to download the additional
PowerPoint presentation.
Agenda
Should J&L hedge all of its exposure to diesel fuel? What percentage of the 17.5
million gallons per month would you hedge? How did you arrive at this
percentage?
What are the pros and cons of using NYMEX contracts versus using the riskmanagement products offered by Continental Bank? Is the use of a monthly
average price a net advantage or disadvantage to J&L? How can Continental hedge
its side of the deal?
Using the estimate of 17.5 million gallons per month, how would you construct a
futures hedge for the following 12 months? How would you construct a commodityswap hedge?
Should Craft consider using an option-based hedge, i.e., caps, floors, collars, or
corridors? Would you recommend that he reduce his overall hedging cost by using
a collar or corridor? What strike prices you should use? Provide graphic
illustrations.
This study source was downloaded by 100000765092775 from CourseHero.com on 05-27-2022 07:08:49 GMT -05:00
https://www.coursehero.com/file/76104143/JL-Railroadpdf/
1. Should J&L hedge all of its exposure to diesel fuel?
How did we proceed
Objective: the aim is to determine the proportion of the exposure that should
optimally be hedged.
Optimum hedge ratio (minimum variance). What we need to calculate is:
The standard deviation of the change in spot price during the hedge period;
The standard deviation of the change in future price during the hedging period
(as the correlation between Heating Oil and Diesel Fuel prices is very high
(0,99), it is possible to hedge the company’s fuel exposure thanks to Heating
Oil Futures Contracts);
Coefficient of correlation between the change in spot price and the change in
futures price.
Our results
Since the oil market is facing a crisis in demand, we decided to hedge about
50% of our exposure.
The reason why we made this choice is that we want to avoid hedging more
than how much we will purchase.
Our decision, moreover, is supported by the data in the following slide.
1. What percentage of the 17.5 million gallons per month would you
hedge? How did you arrive at this percentage?
This study source was downloaded by 100000765092775 from CourseHero.com on 05-27-2022 07:08:49 GMT -05:00
https://www.coursehero.com/file/76104143/JL-Railroadpdf/
2. What are the pros and cons of using NYMEX contracts versus using
the risk-management products offered by KBNC?
2. Is the use of a monthly average price a net advantage or disadvantage
to J&L? How can Continental hedge its side of the deal?
Use of monthly average
This study source was downloaded by 100000765092775 from CourseHero.com on 05-27-2022 07:08:49 GMT -05:00
https://www.coursehero.com/file/76104143/JL-Railroadpdf/
It is either an advantage and a disadvantage:
The average price would include several and different prices which are effected
by many factors during a month period coming up with a more reasonable
result and avoiding the daily changes effects;
The settlement after 12 months complicates the choice of quantity to be hedge
and it doesn’t meet our need, which is to buy 12 different contracts with
different maturity.
Process description
In order to offset the risk taken by KCNB it has to get an opposite position in the oil
market by offering a contract for the hedging needs of oil sellers:
A swap with the fixed price (which the bank has to pay) below $ 1.522 and the
same variable price (which the bank receives) and it gains the spread with no
risk.
3. Using the estimate of 17.5 million gallons per month, how would you
construct a futures hedge for the following 12 months?
How to calculate
The optimal number of contracts (N*) to hedge a portfolio consisting of NA
number of units, where Qf is the total number of futures being used for hedging
and h* is the hedge ratio, is:
This study source was downloaded by 100000765092775 from CourseHero.com on 05-27-2022 07:08:49 GMT -05:00
https://www.coursehero.com/file/76104143/JL-Railroadpdf/
N*=(h*NA)/Qf
3. How would you construct a commodity-swap hedge?
Commodity swap
A commodity swap is a contract where two sides of the deal agree to exchange cash
flows, which are dependent on the price of an underlying commodity. A commodity
swap consist of a floating leg component and a fixed leg component. The floating
leg component is tied to the market price of the underlying commodity or agreed
upon commodity index, while the fixed leg component is specified in the contract.
This study source was downloaded by 100000765092775 from CourseHero.com on 05-27-2022 07:08:49 GMT -05:00
https://www.coursehero.com/file/76104143/JL-Railroadpdf/
With current market conditions, the futures market was expecting price to
trend up from the spot of $1.36 to an average of $1.52 over the next 12 months.
KCNB was currently quoting the 12-month swap price for heating oil as
$1.522/gallon.
Thus, a swap is a custom-fit futures contract, where KCNB is carrying the credit
risk. The settlement occurrs at the end of the swap (12 months). In this way we can
eliminate the market risk: what we receive from the bank will be used the purchase
the diesel in the market (floating),in exchange we pay the fixed price of the swap.
4. Should Craft consider using an option-based hedge, i.e., caps, floors,
collars, or corridors?
Cap
A floor is a purchase of a call option. With this instrument we are able to hedge
an increase of oil prices and, at the same time, we could benefit from a price
decrease by not exercising the option even if we have to pay the premium.
Floor
The selling of a put option is not a convenient as in case of a price increase we
could only gain the premium. As for any option, J&L would need to pay KCNB
a premium for the cap.
Collar
This is a combination of a put and a call option. It is a useful instrument since
it hedges not only the exposure in case of a price increase but also it allows to
gain the premium spread in case of a price stagnation. It limits the movement
of prices within the range of the cap and floor strike simultaneously.
This study source was downloaded by 100000765092775 from CourseHero.com on 05-27-2022 07:08:49 GMT -05:00
https://www.coursehero.com/file/76104143/JL-Railroadpdf/
Corridor
The corridor is a combination of buying a call option and selling another call
option with a higher strike price. In our situation it is not useful because we
are hedged only if the price does not overtake the strike price of the sold call
option.
4. Would you recommend that he reduce his overall hedging cost by
using a collar or corridor? What strike prices you should use? Provide
graphic illustrations.
Collar
In Collar Options the company is hedged against both a price increase and price
decrease.
This study source was downloaded by 100000765092775 from CourseHero.com on 05-27-2022 07:08:49 GMT -05:00
https://www.coursehero.com/file/76104143/JL-Railroadpdf/
The put option allows the company to be hedged against price decrease, on the
contrary if the price will raise the company will lose only the put premium
(0,394).
The call option acts in the opposite way, if the price will go down the company
will lose only the premium (0,371). If the stock price will raise the company
will exercise the call option (and fix the price).
Buy call low
Sell call high
Corridor
In Corridor Options the company is hedged against a price increase.
The long call allows the company to set a cap at a specific strike price.
The short call is set an higher strike price, so to offset part or all of the
premium to the purchased cap.
The company is protected if the stock price stays between the two strike price. It
will be exposed if the stock price will overcome the second cap’s exercise.
This study source was downloaded by 100000765092775 from CourseHero.com on 05-27-2022 07:08:49 GMT -05:00
https://www.coursehero.com/file/76104143/JL-Railroadpdf/
Buy call low
Sell call high
We suggest to use a Collar
Using a collar will hedge making sure to limit losses consisting in the two premium
prices. In fact, if the price will decrease we would exercise the put option earning
from the long put position. On the other hand if the price will increase we will do
the same from our long call position. While, if we decide to het a corridor. We
would offset the premium price but we would run the risk of loosing in case of an
increase above the strike price (second cap) oh the call option we have sold (short
call).
Additional file:
PowerPoint Presentation. Download here.
ABOUT US
SELL YOUR CASE SOLUTIONS
© 2020 CASEHERO.COM · YOU LOOK GREAT TODAY · PRIVACY · IMPRINT & TERMS
This study source was downloaded by 100000765092775 from CourseHero.com on 05-27-2022 07:08:49 GMT -05:00
https://www.coursehero.com/file/76104143/JL-Railroadpdf/
Powered by TCPDF (www.tcpdf.org)