“Today” is late March. Your company, Mesquite Bush Refining Inc., produces 42,000,000 gallons of ultra low...

“Today” is late March. Your company, Mesquite Bush Refining Inc., produces 42,000,000 gallons of ultra low sulfur diesel (ULSD) fuel at the end of each month. You have the following market data.

Spot price of ULSD diesel fuel: S₀ = $2.00/gal.
Futures price of June NYMEX New York Harbor ULSD futures: F₀ = $1.84/gal.
Size of the underlying for this futures contract: 42,000 gallons
Trading in a NYMEX New York Harbor ULSD contract ceases shortly before the contract month begins. For this analysis, assume that time to expiration of the June contract (more precisely, time until the start of the delivery month) is T = 2/12 year.
Your storage cost for ULSD diesel is $0.125 per barrel per month. Assume that you must pay in advance.
Continuously compounded one-month risk-free rate: r = 2% per year.

Given current spot and futures prices, should your company hedge its late May sale with ULSD futures? If yes, what hedging strategy should you adopt? (Assume that your company is willing to hedge only at a “fair” price or better.)

Group of answer choices

Hedge: take a long position in 1,000 June ULSD futures contracts. Close out your futures position in late May.

Hedge: take a short position in 100 May ULSD futures contracts. Close out your futures position in late May.

Hedge: take a short position in 1,000 June ULSD futures contracts. Close out your futures position in late May.

Hedge: take a long position in 100 May ULSD futures contracts. Close out your futures position in late May.

Do not hedge with USLD futures.

Solutions

Expert Solution

SInce the company is a producer of ULSD, the risk to the company is if the prices move lower.

It can protect itself from this risk by entering into a short futures contract.

Since its exposure is 42Mn gallons and the contract size is 42000 gallons, it would have to short 1000 contracts

F = Se^rt + s*e^rt where S is the spot and s is the storage cost, r is the RFR and F is the forward price and t is the time to maturity

Storage cost is given per barrel...1 barrel is 42 gallons. Therefore the storage cost for 42Mn gallons = USD 125000

Storage cost to be embedded in futures price = (125000 e^(0.02*1/12) + 125000e^(.02*2/12))/42000000 (since it is paid in advance)

Therefore F = 2.0067 + 0.0060 = USD 2.0127

However the price of the June contract is much lower. The market should be contango. It is instead in backwardation. The company should therefore not hedge using the June NYMEX New York Harbor ULSD futures

jeff jeffy answered 1 year ago

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