In the northeast United States and in eastern Canada, many people heat their hou

Question

In the northeast United States and in eastern Canada, many people heat their houses with heating oil. Imagine you are one of these people, and you are expecting a cold winter, so you are planning your heating oil requirements for the season. The current price is $2.25 per US gallon, but you think that in six months, when you'll need the oil, the price could be $3.00, or it could be $1.50.

If you need 350 gallons to survive the winter, how much difference does the potential price variance make to your heating bills?

If your friend Tom is running a heating oil business, and selling 100,000 gallons over the winter season, how does the price variance affect Tom?

Which one of you benefits from the price increase? Which of you benefits from price decrease?

What are two strategies you can use to reduce the risk you face? Could you make an agreement with Tom to mitigate your risk?

Assuming you are both risk-averse, does such an agreement make you both better off?

In the northeast United States and in eastern Canada, many people heat their houses with heating oil. Imagine you are one of these people, and you are expecting a cold winter, so you are planning your heating oil requirements for the season. The current price is $2.25 per US gallon, but you think that in six months, when you'll need the oil, the price could be $3.00, or it could be $1.50.

If you need 350 gallons to survive the winter, how much difference does the potential price variance make to your heating bills?

If your friend Tom is running a heating oil business, and selling 100,000 gallons over the winter season, how does the price variance affect Tom?

Which one of you benefits from the price increase? Which of you benefits from price decrease?

What are two strategies you can use to reduce the risk you face? Could you make an agreement with Tom to mitigate your risk?

Assuming you are both risk-averse, does such an agreement make you both better off?

Explanation / Answer

CURRENT PRICE=$ 2.25 TOTAL EXPENDIUTRE=350*2.25=787.5

INCASE THE PRICE GOES UP i.e. $3 THEN TOTAL EXPENDITURE= $1050

IN THIS CASE EXCESS EXPENDITURE WOULD BE =1050- 787.5=$ 262.5

variance is unfavourable BY$ 262.5

INCASE THE PRICE DECREASES TO $ 1.50,TOTAL EXPENDITURE =$525

IN THIS CASE ,THE EXPENDITURE WILL BE LOWER BY= 787.5-525 =$262.5

variance favourable BY $262.5

FOR TOM CURRENT REVENUE = 100,000*2.25 =$225000

INCASE THE PRICE GOES UP i.e. $3 THEN TOTAL REVENUE=100,000*3=$300,000

EXCESS REVENUE=300,000-225000 =$75000

variance is favourable BY $75000

INCASE THE PRICE DECREASES TO $ 1.50,TOTAL REVENUE= 100,000*1.5 =150000

REVENUE WILL BE LOWR BY=225000-150000=$75000Â

variance is unfavourable $75000

FIRST STRATEGY WOULD BE TO BUY THE OIL AT THE PRESENT STAGE AND TO STORE IT FOR FUTURE USE.

SECOND STRETEGY IS TO REDUCE THE USE OF OIL Â .i.e. TO DECREASE THE QUANTITY DEMANDED.Â

BUT THERE Â IS NO SUCH AREEMENT TO MITIGATE MY RISK BECAUSE IN CASE ONE OF US WILL HAVE TO BE AT UNFAVOURABLE VARIENCE.

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