Question

Snooky Inc believes its biggest risk is that fuel prices increase and require it to raise its prices. Accordingly it decides to hedge this risk by purchasing a forward of 10M barrels of fuel. Let’s assume the price of the contract is $100/barrel. If the price of fuel increases to $105 by the end of the contract, how much will Snooky pay per barrel for it’s fuel? Show all work.

How much total money would Snooky have saved or lost if it hadn’t entered into the forward contract? Show all work.

Answer 1

Solution:
	Snooky will pay =$100 per barrel
	Total money would Snooky have lost if it hadn’t entered into the forward contract = $50 million
Working Notes:
	Forward contract is contract in which we get rate of contract fixed at future date.
	As the Snooky Inc entered into Forward contract its cost per barrel is fixed , so as the price per barrel increases to $105 but we have already have a forward contract of $100 per barrel we need to pay only $100 per barrel.
	if it hadn’t entered into the forward contract it have to pay the rate prevails at the date of payment which is $105 per barrel in our case.
	If we have entered into forward contract we have to pay only $100 per barrel
Hence,
	Snooky have lost if it hadn’t entered into the forward contract = Forward rate - Spot rate at payment date
			=$100 - $105
			= -$5 per barrel
	That is loss per barrel of $5
	Total loss amount = Loss per barrel x Total contract size
	= $5 x 10 million
	= $50 million loss
Please feel free to ask if anything about above solution in comment section of the question.