Derivatives and Risk Management Case
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DerivativesandRiskManagementCase.docxDerivatives and Risk Management Case
The market for soybean derivatives has a significant impact not only on the food & beverage industry but on other industries as well. In 2015, the global market is estimated to be led by the Asia-Pacific region, where China is the major consumer. North America is the second-largest region with regards to the application of soybean derivatives. The United States as the largest soybean export country should joint ventures, expansions, and acquisitions have been the key moves undertaken by market players for global expansion.
The second chart demonstrate that price of soybean has big crush in 2015 and gets warm in 2016 but the price still unpredictable in the future. But for Companies such as Bunge Ltd (U.S.), Archer Daniels Midland Company (U.S) Cargill, and Incorporated (U.S.) are key players of the soybean derivatives market. These companies use various strategies to achieve growth and development in the market. Those companies are trying to acquire soybean at the lowest price and produce products. Therefore, hedging strategy for the company is very important for management to control the operating expenses. Since the current soybean price is high when compared with that in 2016, If the soybean price continues to rise, the company will benefit from the hedging, otherwise, the company will lose money.
There will be 5 alternatives for management to deal with the risk.
1. Do nothing
2. Using a fixed price swap agreement to hedge
3. Using call options to hedge
4. Using a zero cost collar strategy to hedge
5. Using a crude oil futures contract
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1 |
Do nothing |
Market volatility will directly affect the operating expenses, if the price increases, the operating expenses will increase, if the price decreases, the operating expense will decrease. |
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2 |
Fixed price swap agreement |
The company pays a fixed price and receives a floating price for jet fuel use during each monthly settlement period. Since it is a customized contract arrange in the OTC market, so the volume of fuel hedged is negotiated. The swap agreement will make up the difference when fuel price increase and removes difference when fuel price decline. In this case, the payment for fuel is fixed. But the company still can result in a loss if the predict for the price is wrong. |
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3 |
Call options for crude oil |
Buy call option, If the price increase, the call option can be exercised and the option can make a profit, they would offset the loss from the actual price rise of the commodity. If the price decrease, the call will not be exercised. So the company can take the advantage from the call option, the company can benefit a lot when compare with fixed price swap agreement, but the call option requires a premium, so when price goes down, do nothing is the best choice, but it is better to pay the premium to manage the risk for price going up. |
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4 |
Collar Strategy for crude oil |
Buy the call option and sell the put option. It is a zero cost collar because the premium of both the options are the same. The premium paid and received will be offset. The call option’s strike price is higher the the put option’s. In this scenario, if the fuel price goes up above the strike price, the call option will be exercised, the company can offset the loss form the fuel prices increase without cost. If the fuel price goes down, but not below the put option’s strike, company and buyers will not exercise the options, the company can take the advantage from the price decline just as “do nothing”. However, if the price declines below the strike price, the buyers will exercise the put options, the company need to pay the difference between strike price and spot price, so the maximum loss will be the strike price amount for per contract. The risk is pretty high. |
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5 |
Future contract for crude oil |
A future contract is an agreement to buy or to sell a specified quantity and quality of a commodity for a certain price at a designated time un the future. The airline has a long positon to offset against the fuel price rise. It is an obligation and there is a daily settlement to minimize the chance of default. So the future price will affect the gain and loss in the future contract. If the price goes up above the contract price, the airline will benefit from it, if the price goes down, the company will have a loss (difference between contract price and the spot price) |
The main objectives of airline operators are to minimize the fuel costs and to reduce the volatility of fuel cost. It is important to know that when no hedging takes place, there is no cost will incur and there is no offset of risk or protection against fuel rise. So this could be the benchmark when consider which strategy could apply.
