Future Contract Size (Units) Standard Deviation (%) Historical Correlation Futur

Question

Future Contract Size (Units)

Standard Deviation (%)

Historical Correlation

Futures Contracts Heating Oil Crude Oil Jet Fuel

4. There are three primary airlines in the United States: Delta, American, and United. A major cost to airlines is jet fuel; assume United is the only airline in the industry who decides to hedge the need to purchase jet fuel. Which of the following statements is most accurate:

A.) By entering a short hedge using future contracts, United should expect a less stable (more volatile) operating margin (EBIT/Sales) than Delta or American.

B.) By entering a long hedge using future contracts, United should expect a less stable (more volatile) operating margin (EBIT/Sales) than Delta or American.

C.) By entering a long hedge using future contracts, United should expect a similar volatility in operating margin (EBIT/Sales) compared to Delta or American.

D.) By entering a long hedge using future contracts, United should expect a more stable (less volatile) operating margin (EBIT/Sales) than Delta or American.

E.) By entering a short hedge using future contracts, United should expect a more stable (less volatile) operating margin (EBIT/Sales) than Delta or American.

5.) Assume it is October 2017 and United needs to purchase 10,000 K units of Jet Fuel 3 months from now in January 2018. To hedge this risk, United decides to use the January 2018 Jet Fuel contract (which has the exact same date United needs to purchase the Jet Fuel). Which of the following statements is (are) TRUE:

I. At contract expiration when delivery occurs (January 2018), the basis of the hedge is at or near zero

II. If United instead needed to purchase the Jet Fuel in Dec. 2017, United would be exposed to basis risk

III. If there were no such thing as futures contracts on Jet Fuel, United would be exposed to basis risk

A.) I

B.)II

C.) III
D.) II, III

E.) I, II, III

Explanation / Answer

4 - The correct answer is a long hedge since United is a buyer of jet fuel. Also, hedging should give it a more stable operating margin. Hence, the correct answer is D.

5- Basis risk is the risk that the value of a futures contract (or an over-the-counter (OTC) hedge) will not move in line with that of the underlying exposure. Alternatively, it is the risk that the cash futures spread will widen or narrow between the times at which a hedge position is implemented and liquidated.

Other forms of basis risk include ‘product’ basis, arising from mismatches in type or quality of hedge and underlying. This would occur when there is no such thing as futures on Jet fuel.

The correct answer is E. All the three statements are true.

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