J&L and Hedging
J & L Railroad
1. J & L can use heating oil futures to hedge its exposure to diesel fuel prices. Which futures position should J & L take? Explain.
J&L Railroad should take a long position. They need to purchase diesel fuel in the future, they don’t produce diesel fuel, so they would want to take a future to be able to lock in the price of diesel fuel for future purchases.
2. What problems could the use of heating oil futures for hedging create for J&L?
Note: I assume this question is asking about heating oil specifically not futures in general.
As heating oil is not the same product as diesel fuel, therefore there could still be some exposure (risk) for J&L.
There has been a historical correlation between heating oil prices and diesel fuel prices, but this might not be true for the future.
The futures for heating oil are contracts for delivery of 42,000 gallons – the amount of diesel fuel needed in any month is unlikely to equal 42,000 gallons or a multiple of that amount.
As the heating oil futures mature on the last business day of the preceding month and therefore the purchase would have to occur on that day.
3. Explain why the daily settlement of futures contracts can create cash-flow problems for J&L?
If J&L purchases a long future contract, they have to provide the initial margin for each contract. If the price of heating oil goes down (even for a short period) to bring the margin to below the maintenance margin, J&L would be required to top up the margin to the initial margin amount. If they don’t have the ready funds to do this their futures contract would be cancelled.
This could require J&L to maintain a substantial amount of cash or the availability of a line of credit they can draw on, as needed. The costs to hold this much cash or the interest on a line of credit may exceed the value of the hedging of diesel fuel prices.
As the contract hasn’t closed yet (and it could be a while until it does depending on the length of
1. J & L can use heating oil futures to hedge its exposure to diesel fuel prices. Which futures position should J & L take? Explain.
J&L Railroad should take a long position. They need to purchase diesel fuel in the future, they don’t produce diesel fuel, so they would want to take a future to be able to lock in the price of diesel fuel for future purchases.
2. What problems could the use of heating oil futures for hedging create for J&L?
Note: I assume this question is asking about heating oil specifically not futures in general.
As heating oil is not the same product as diesel fuel, therefore there could still be some exposure (risk) for J&L.
There has been a historical correlation between heating oil prices and diesel fuel prices, but this might not be true for the future.
The futures for heating oil are contracts for delivery of 42,000 gallons – the amount of diesel fuel needed in any month is unlikely to equal 42,000 gallons or a multiple of that amount.
As the heating oil futures mature on the last business day of the preceding month and therefore the purchase would have to occur on that day.
3. Explain why the daily settlement of futures contracts can create cash-flow problems for J&L?
If J&L purchases a long future contract, they have to provide the initial margin for each contract. If the price of heating oil goes down (even for a short period) to bring the margin to below the maintenance margin, J&L would be required to top up the margin to the initial margin amount. If they don’t have the ready funds to do this their futures contract would be cancelled.
This could require J&L to maintain a substantial amount of cash or the availability of a line of credit they can draw on, as needed. The costs to hold this much cash or the interest on a line of credit may exceed the value of the hedging of diesel fuel prices.
As the contract hasn’t closed yet (and it could be a while until it does depending on the length of