Quantitative analysis of an alternative hedging strategy

Assignment Help Financial Accounting

Reference no: EM13985388

Write a report 4 to 5 pages maximum, double-spaced...note that any data exhibits do not count toward the 5-page maximum). And complete spread sheet.

The VP of VUL Air containing the following elements

*Note* Professor is NOT your audience, so be careful about your assumptions regarding your reader's knowledge of the subject matter.

Paper will be assessed based on the following factors:

1) Correctness of content,
2) Completeness of elements below,
3) Rigor of analyses and creative judgment employed in designing analyses, and
4) Effectiveness of communication (including professionalism):

The data sources for historical spot and futures prices on crude oil and refined products are available at https://www.eia.gov/petroleum/data.cfm (click on "Prices"), and current oil futures price data are available at https://www.cmegroup.com/trading/energy/.

Case Study

Underlying information for assignment:

The basic scenario: You work for a major US airline, VUL Air, in its fuel purchasing department. During December 2015, your boss, the VP of fuel purchasing for VUL, purchased 2,700 March 2016 light sweet crude oil contracts traded on the CME's NYMEX exchange to partially hedge the company's anticipated February 2016 jet fuel consumption of 116 million gallons. The weighted average price of crude oil futures contracts purchased on the NYMEX during December 14 - 18, 2015, was $38.18 per barrel. Your boss has presented you with the plan for liquidating the 2,700 crude oil futures contracts during February 2016. In fact, you have been provided with a spreadsheet template that shows the plan for liquidating the futures contracts (see column K of the spreadsheet template).

More background information:
• One barrel of oil = 42 gallons of oil.

• VUL Air uses jet fuel on a daily basis, and there are only minor deviations in the scheduled routes from day-to-day. Thus, you can assume that the airline uses the same amount of fuel during each of the 29 days of February 2016.

• VUL Air employs "first-in, first-out" accounting for any jet fuel held in inventory.

• 72.5 million gallons of VUL Air's anticipated jet fuel usage in February 2016 will be purchased at the company's "non-hub" airports on an "as needed" basis. Aircraft are fueled immediately upon landing to prepare for the next departure. Jet fuel deliveries at all non-hub airports are priced at daily spot prices of Gulf Coast jet fuel (reported at the following website https://www.eia.gov/dnav/pet/pet_pri_spt_s1_d.htm). Saturday, Sunday, and holiday purchases of jet fuel are priced at the prior business day's spot price. The website's data is updated once per week on Wednesdays (except for "Monday holiday" weeks in which case the data is updated on Thursdays).

• 43.5 million gallons of VUL Air's anticipated jet fuel usage in February 2016 is used at the company's "hub" airport. The company keeps anywhere from 12 million to 42 million gallons of jet fuel in inventory at oil terminals near its hub airports. All of the hub airport fuel is purchased on the Gulf Coast spot market in bulk quantities (i.e., 250,000 barrels of jet fuel might be a "minimum" spot market order for this airline). Please assume that as of the end of January 2016, the airline holds existing jet fuel inventories of 22.5 million gallons at an average cost of $0.92 per gallon. Your boss has informed you of plans to buy additional jet fuel on the spot market purchases of spot jet fuel during February 2016. A purchase must be made no later than late in the first week of February. Depending upon the size of the spot market purchase in the first week of February, another spot market purchase may be necessary later in the month. You will be informed of the date and price of spot market purchases in an update to this document.

• Your boss has informed you that he plans to liquidate 180 crude oil contracts on each normal trading day of the CME through February 22, 2016 (as this is the last day of trading for the March 2016 contract).

VUL Air typically buys and sells futures contracts just before daily settlement, thus you may assume that each day's settlement price for March 2016 crude oil futures on the CME reflects the futures price at which any contracts are liquidated (see https://www.cmegroup.com/trading/energy/crude-oil/light-sweet-crude_quotes_settlements_futures.html). You need to keep these records yourself, but do not despair if you do not want to track settlement prices daily! Historical data on crude oil futures contract settlement prices are updated weekly at https://www.eia.gov/dnav/pet/pet_pri_fut_s1_d.htm. Through February 22, the March 2016 contract is "Contract 1" on the EIA website.

• Your boss finally informed you that on February 5, 2016, he purchased 1 million barrels of jet fuel (42 million gallons) on the Gulf Coast spot market for $1.02 per gallon. This fuel was delivered into storage facilities near the hub airport for consumption during February and March.

Your boss expects a written report containing the following components:

Facts associated with implementation:
• Documentation of futures contracts liquidated (date, quantity, and price).
• Profit/loss realized on futures contract liquidation.
• Cost of actual jet fuel consumption (based on statements from "Background" section above).
• Total net cost of jet fuel consumed after accounting for effect of hedging profits/losses.
• Did the hedge perform better or worse than expected?

Suggestions for improving the hedging strategy employed by your boss:

• Your discussion should address (at a minimum):
o What mistake(s) did your boss make in devising the futures contract liquidation strategy? Be specific as to how the liquidation strategy should have been altered.
o What mistakes did your boss make in setting the hedge in December? Make sure you recommend what the hedging strategy should have been (be specific).
- Your discussion should contain quantitative analysis of an alternative hedging strategy to the one employed by your boss. In particular, should your boss have considered using an alternative hedging instrument such as futures contracts on gasoline or ultra-low-sulfur-diesel (labeled as "heating oil")?
- Make sure you consider the following key aspects of hedging with futures when you compare between alternative hedging instruments:
• Correlation
• Basis risk
• Minimum variance hedge ratio
• Timing issues of futures contract expiration.

Attachment:- starting-point-for-spreadsheet.xls

Reference no: EM13985388

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