DERIVATIVES AND RISK MANAGEMENT

By completing this case you will:

– Learn to work with futures and spot data

– Estimate hedge ratios

– Compute hedged and unhedged valuation changes with historical data

– Back-test and discuss possible hedging strategies

– Consider how hedge ratio estimates can be employed in dynamic settings

– Communicate complex analysis to a non-technical audience

Learning Activities

By completing this case you will:

– Estimate and/or compute hedge ratios

– Compute cash flows to hedging strategies using energy futures contracts

– Comment on the consequences of changing market conditions on

possible hedging strategies

– Write a brief report for a non-technical audience

 Task

You are an associate at a commercial bank. One of your colleagues has sent the

following email:

“Thanks again for sending Hull’s chapter on hedging with futures. As you

know we do a lot of work with energy-intensive companies, so one of his

examples seemed especially relevant. His cross-hedging strategy (jet fuel and

heating oil) is interesting, but we were wondering what would happen in

turbulent markets? For example in 2014 crude oil dropped from about USD

100 per barrel to around USD 50 per barrel. What would happen to someone

using Hull’s proposed strategy over this time? Would it make sense to

consider other energy futures as part of a hedging strategy (i.e. we have been

wondering about including crude oil futures in addition to heating oil)?

Any thoughts you have would be greatly appreciated.”

Your colleague has limited quantitative skills and so you feel that you can best

demonstrate these concepts through a clear example, based on data taken from the

period she noted