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J&L and Hedging Essay

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 the contract) these daily settlements could affect the interim cash needs of the company.

If the price goes up there isn’t an issue with cash needs (other than the initially required margin).

4. How do options on futures work? Why can trading options on futures can be preferable than trading options on the physical heating oil? An option on a future is the ability to purchase the future (or sell the future) at a given price. If the future doesn’t reach that price, you don’t have to buy it. An amount called a premium is charged for the options.

If instead of trading options on a future, J&L could trade options on heating oil. Exercising an option on a future only requires the cash margin to be deposited, exercising an option on heating oil would require the total value of the heating oil exercise price to paid.

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