Question

It’s April 2020. You are an oil distributor, planning to buy 500,000 barrels of crude oil from British Petroleum (BP) in April 2021 in exchange for a spot price prevailing at that time. Because April 2021 spot price is unknown today, yourobjective is to hedge this risk. Suppose that the only available contract is for May 2021 delivery. Today the futures priceof crude oil for May 2021 delivery is $105.37. Contract size for crude oil is 1000 barrels. Assume that there is noexcessive volatility during delivery month.

1. If you were to hedge using futures market, would you enter short or long futures position in April 2020?Explain. (5 pts)

2. What contracts and how many contracts do you need? (5 pts)

Suppose that in April 2021 the futures contract’s price turns out to be $95.00 a barrel and spot price turns out to be$90.00 a barrel

3. Calculate total profit or loss on your futures position (6 pts)

4. What is the overall price per barrel paid by the oil distributor in April 2021 after taking into account profits orlosses on the futures position? Show your calculations. (6 pts)

Now suppose that in April 2021 the futures contract’s price turns out to be $115.00 a barrel and spot price turns out tobe $125.00 a barrel

5. What is the overall price per barrel paid by the oil distributor in April 2021 after taking into account profits orlosses on the futures position? Show your calculations. (6 pts)

Answer 1

I would go long on futures for May 2021 Contract as I have to buy the oil barrells. In futures market you go long when you have to buy in future and short on futures when you hae to sell in future
Per Barrel	105.37
Contract Size	1000
Cost of 1 contract	$       1,05,370.00 (105.37*1000)
Ttoal Futures value	$ 5,26,85,000.00 (cost of 1 contract * Tota no of contract)
500000	Barrel requirement
500.00	Contracts will be needed to hedge the position (500,000/1000)

Scenario 1
		Per barrell - You will sell the contract at the futures price @ 21 April 2021 @ $95
Spot	$                   90.00	$    4,50,00,000.00	Total purchase price of the contract = Spot price in April 2021 * No of barrels
Future	$                   95.00	$                     -10.37	This is loss per barrell (95-105.37)
		$            -10,370.00	Loss per contract = Loss per barrell * Contract size
		$      -51,85,000.00	Total loss in Futures

Total Price paid per barrell after taking into account Profit or loss	Purchase price + loss on futures
		50185000	100.37 (50185000/500000)	Price per barrell after P&L

Scenario 2
		Per barrell - You will sell the contract at the futures price @ 21 April 2021 of $125
Spot	$                 125.00	$    6,25,00,000.00	Total purchase price of the contract = Spot price in April 2021 * No of barrels
Future	$                 115.00	$                         9.63	This is Profit per barrell (125-105.37)
		$                9,630.00	Profit per contract = profit per barrell * Contract size
		$        48,15,000.00	Total Profit in Futures

Total Price paid per barrell after taking into account Profit or loss
		Purchase price - Profit on futures
		57685000	115.37 (57685000/500000)	Price per barrell after P&L