Question

Class Example-A Short Hedge It is May 15. An oil producer has negotiated a contract to sell 1 million barrels of crude oil. The price in the sales contract is the spot price on August 15. The current spot price of crude oil is $19.00 per barrel, and the August crude oil futures price is $18.75 per barrel. Each futures contract is for the delivery of 1, 000 barrels of crude oil. List the transactions with which the oil producer can hedge.

Answer 1

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Strategy -

The company hedge its exposure by shorting 1000 futures contracts . By doing this strategy firm should be to lock in a price close to $18.75

Irrespectively increase or decrease in price firm will be getting cash of 18.75 million .

Situation if price increases

Suppose that the spot price on August 15 is $17.50 The company realizes $17.5 million for the oil under its sales contract. The gain from the futures contracts is        $18.75-$17.50=$1.25 per barrel. Total amount is $17.5+$1.25=$18.75 million

Situation if price decline

Suppose that the spot price is $19.50 on August 15. The company realizes $19.50 million from the contract and loses $19.50-$18.75=$0.75 per barrel. Total amount is $19.5-$0.75=$18.75 million