Problem 1. (Hedging with forward contracts) The Specialty Chemical Company operates a crude oil refinery located in New Iberia, LA. The company refines crude oil and sells the by-products to companies that name plastic bottles and jugs. The firm is currently planning for its refining needs for one year hence. Specifically, the firm's analysts estimate that Specialty will need to purchase 1 million barrels of crude oil at the end of the current year to provide the feed stock for its refining needs in the coming year. The 1 million barrels of crude will be converted into by-products at an average cost of $10 per barrel, which specialty expects to sell for $170 million, or $170 per barrel of crude used. The current spot price of oil is $115 per barrel and Specialty has been offered a forward contract by its investment banker to purchase the needed oil for a delivery price in one year of $120 per barrel.
a. Ignoring taxes, what will Specialty's profits be if oil prices in one year are as low as $100 or as high as $140, assuming that the firm does not enter into the forward contract? (Round to the nearest dollar)
b. If the firm were to enter into the forward contract, demonstrate how this would effectively lock in the firm's cost of fuel today, thus hedging the risk of fluctuating crude oil prices on the firm's profits for the next year.
Price of Oil/bbl Unhedged
Annual Profits
$100 $____
$105 $____
$110 $____
$115 $____
$120 $____
$125 $____
$130 $____
$135 $____
$140 $____
Problem 2.(Margin requirements and marking to market) Discuss the exchange requirements that mandate traders to put up collateral in the form of a margin requirement, and use this account to mark their profits or losses for the day, designed to eliminate credit or default risk.
Since both parties have or neither party has to post margin when they enter into a futures contract, and because they mark to market on the delivery date or every day until the delivery date, we are assured or not assured that the party and the counterparty to the contract have already posted the gain or loss to the other, and the risk of default still exists or is thereby negated.