Crude oil problem

Question

Suppose XYZ Airlines Ltd, better known as Superair, is XYZ’s third largest airline. Its passenger service and freighter network covers destinations across the Asia Pacific area. Since of the rising price of crude oil, Superair suffered a huge loss in the past fiscal year, so its financial manager is considering using derivatives to hedge the crude oil price.

a) Assume Superair has to purchase 5 million US barrels of crude oil on June 1. Using the information listed in the table shown below, develop a hedging strategy for Superair to hedge the crude oil price and explain the effective cost/price paid by Superair for the crude oil per barrel after incorporating the gain and loss in the futures positions. Define clearly the buy or sell futures position of Superair and the number of contracts required. Crude oil futures trade in units of 1,000 US barrels.

b) Compute the bases on April 1 and June 1 and explain whether the hedge by Superair is a perfect hedge using the concept of basis risk.

Answer 1

a) Super air has an exposure to pay 5 million US barrels of crude oil  on June 1st. it should buy Crude Oil futures of  5000 units of July crude Oil futures at $ 79 per unit .. When the payment is made in June 1  the futures position  will  be closed at  $83.5 per unit

Buying price of the  futures  $79.0
Selling price of the futures   $83.5
Profit per contract               $ 4.5

If 5000 units are purchased, then the total profit when closing the position will be $ 4.5x1000x5000= $22500,000
The payment will be made at the spot rate of $ 74 which will be 5000X1000X74= $370000000
The net cost of payment will be $ 370000000 – 22500000 = $ 347500000
The net cost paid per barrel is $ 69.5

b) Basis is the difference between the future prices and the current ‘cash market’ price of the underlying security

The current price on April 1st of the July crude Oil futures is $79 and the spot rate is $70. The size of the basis at this time in April 1 would be $79-$70= $9

The current price on June 1st of the June crude Oil futures is $83.5 and the spot rate is $74. The size of the basis at this time in June 1 would be $83.5-$74= $9.5

Basis risk is the risk when the futures are closed the size of the basis is different from the expectation when the hedge was created. In the above case the when the futures are closed in June 1 the actual basis is $ 9.5 which is higher by $ 0.5 than expected when the hedge was created. Hence it is perfect hedge using the concept of basis risk.