Hedging Oil Consumption Essay Example | Topics and Well Written Essays - 1500 words

Hedging Oil Consumption - Essay representativeThere are other inherent risks associated with business such as currency fluctuations, volatility of pure(a) oil costs and so on. In order to reduce exposure to volatility in the market, many participants pick hedging strategies using derivatives. A derivative is a financial instrument which derives its value from the underlying asset. wholeness of the hedging strategies alternatives that are available to the market participants is by using futures derivative. The main purpose of futures markets is to minimise suspicion in transactions and hence reduce risk. The basic objective of futures market is to wangle the associated risk by taking such a position so as to neutralize possibility of risk as far practicable. A futures contact is a standard contract between two market participants to misdirect or dispense a specific asset of standard quality, quantity for a given value agreed upon on the date of contract ( excessively known as strike price) with payment and delivery occurring at maturity date. The contracts are standard in the sense that quantity, quality, price, strike price, delivery date, initial margin, marking to market, and so on are done via intermediary and not directly negotiated between parties involved in transaction. Hence, the refinery may place down into futures contract with its customers giving them the opportunity to purchase oil at current prices at a later date in future. In this way even if the prices of oil rises in future, the refinery would not require to somersaulting on the higher costs to their customers (CME, 2006, pp.49-53). After discussing the concept of futures, it is now important to illustrate how futures might helper the US Gulf refinery to hedge risk. There are two different methods of hedging namely gyp hedge and long hedge. A improvident hedge is suitable when the hedger owns the asset (as in this case) and expects it to sell at some time in future. Thus, the o il refinery may take short position in futures contract. A long hedge on the other hand involves taking the long position (buy at later date). This strategy is suitable when the hedger (in this case customer) knows that it will have to purchase a particular(a) asset in future but would like to purchase at current price. In twain the strategies payment and deliver occurs at maturity of contact which is usually three months. To further illustrate these strategies in details, consider the following example Assuming that on June 13 (present) the oil refinery has taken a short position by negotiating a contract to sell 1 million barrel of crude oil. It is also agreed that the price applicable in the contract will be on the market price of family 13. So, for each 1% rise, the producer will gain $10,000 and similarly for each 1% objurgate in price refinery will lose $10,000. The standard futures contract on CME platform is 1,000 US barrels (or 42,000 gallons), hence the company can hedg e exposure by shorting 1,000 September futures contracts. If the last trading closing curtain price was $90 per barrel, strike price is $85 and assuming that price per barrel in September is actually $80, then per barrel gain of the oil refinery would be $5 (since, $85 - $80). This means the numerate gains for entire contract would be $5000 ($5 x 1000). Using the above example the long hedge strategy can be explained as