Question

Scenario You are a commodity manager hedging British Airways’ price exposure to jet fuel oil for the next 2 years. The company requires 100,000 gallons per month (1,200,000 gallons p.a.) of jet fuel oil. Time period is Jan21-Dec21.

Task/ Procedure

In a report of no more than 1000 words, create a risk management strategy to explain how to minimise BA’s price risk exposure. It is expected that you will explain your strategy, using your own data and your own research, your hedging strategy in order to minimise price risk. Your strategy can include the use of swaps, options, futures, complex hedging strategies and buying on the spot and also not hedging certain time periods at all. Append all your workings/ calculations to the report.  

Answer 1

Commodity Price Risk arises from unexpected increases in commodity prices which can affect the profit margin . Buyers can protect themselves from such risk by purchasing a contract which will assure a specific price for such commodity . Forward , Futures and options can be used to hedge such price risk . Price risk can arise due to adverse fluctuations in world prices , exchange rates .

We can take the help of Fuel Hedging which is a contractual tool to hedge the price volatility . It uses options and commodity swap to establish a cap . .

Swap - It is an agreement where one party exchanges their exposure to a floating fuel price for a fixed fuel price . For example :

Quantity : 1200000 gallons

Fixed Price : 25 pound per gallons

Floating : NCDEX

Start Month : Jan 2021

End Month : Dec 2021

Buyer of swap : British Airways

Suppose floating Rate comes to 30pound Then The british airways will gain 5 pound per gallon . This would reduce the cost by 5 pound per gallon .If the FLoating rate is 20 pound then british airways will loose 5 poung per gallon . This would increase the cost by 5 pound per gallon .

Call option it provides the buyer with a hedge against rising prices . It requires an upfront premium . For example

Strike price = 1.5 poung per gallon

Premium = .0750pound per gallon

if the current underlying price DEc 2021 is 1.46 pound then we are out of money . No gain cost incurred will be th premium . If the current underlying price Dec 2021 is 1.55 pound then we are in the money . Gain will be .5 pound minus the premiuim paid