Question

During March 2020, an airline buys 42 million gallons of jet fuel in the Gulf Coast to fuel its planes at a weighted average price of $1.75 per gallon. In mid-December of 2019, the airline bought 920 April 2020 crude oil futures contracts at the prevailing futures price of $63.00 per barrel (NOTE: each futures contract has an underlying of 1,000 barrels of crude oil). On the same date that the futures contracts are purchased, the VP observes that the spot price of Gulf Coast jet fuel is $1.80 per gallon. (NOTE: one barrel of oil - 42 gallons of oil). During March 2020, the airline sells its crude oil futures contracts at a weighted average price of $54.60 per barrel. a. Calculate the hedge ratio that the VP of fuel purchasing used. (3 pts) b. Calculate the airline's gain (loss) on the futures contracts. Please make sure to state this amount in total dollars. (4 pts) c. Calculate the airline's net cost of jet fuel (i.e., effective purchase price) for March 2020 including the effects of the futures contracts. (6 pts) d. Did the VP's hedge perform better or worse than hoped? Please provide a brief discussion (including specific numeric comparisons or analysis) to justify your answer. (5 pts)

Answer 1

a.Hedge Ratio:

Hedge Ratio=Total amount of hedge/Total amount on the assets

Total amount of asset to be purchased =42 million*$1.80=$75.60 million

Total amount of hedge=920*1000*$63.00=0.92 million*$63.00 =$57.96 million

Hedge Ratio=57.96/75.60=0.7667

b.Gain/(Loss) in Futures Contract:

Purchase Price of futures contract per barrel=$63.00

Quantity Purchased in Future Contract =0.92 million barrels

Selling Price in futures per barrel=$54.60

Total Loss =(63.00-54.60)*0.92 million=$7.728 million

Total Loss=$7,728,000

c.Net Cost of Jet Fuel

Purchase Cost=42 million*$1.75=$73.50 million

Loss in futures =$7.728 Million

Total Cost =73.5+7.728=$81.228 million

Effective Purchase Price Per Gallon=$81.228/42=$1.9340

d.Hedge performed worse than hoped .

Hedge was undertaken for risk of price increase

Purchase Price in future=$1.5 per gallon

The Spot price of asset purchase was $1.75 per gallon

But the futures were sold at average price of 54.6/42=$1.30 per gallon which was lower.