According to the article of FT.com entitled \'Oil rises as US crude stocks retre
ID: 1175266 • Letter: A
Question
According to the article of FT.com entitled 'Oil rises as US crude stocks retreat for third week (26.04.2017), three major oil forecasting agencies (the US Energy Information Administration, the International Energy Agency, and the Organization of the Petroleum Exporting Countries) forecast that the global oil market will be in deficit in the second half of this year if the cartel maintains its production cuts at its next meeting on May 25'. An extension of production cuts in combination the decline in the US crude stocks will put pressure to the markets and boost prices. Based on the information above describe how financial derivatives (crude oil futures) could be used in risk management (hedging) and speculation. For your example, please use real data to support your opinion. Your answer should be presented in a professional wayExplanation / Answer
Derivatives - Derivative is a contract between two or more parties for the purpose of hedging by buying or selling the derivatives based on underlying asset. Underlying asset can be shares, commodities, swaps etc.
Future contract- It is a contract of buying or selling an asset at specific price in the future.
Application of Crude Oil future- Crude oil producers have the price fear, if they expect that price of crude will come down in the near future, they can take the short position in crude oil future contract. It is called Short Hedge. Crude oil producer sells Crude oil future contract in the future market. so as to minimize the loss and cover the produced quantity of crude oil.
Example: ABC is a Oil extraction company which sees the price drop in crude oil in next three months so it enters into the three months future contract where the spot price of crude oil is $48.50/Barrel and future price is $48/Barrel. ABC company wants to lock in the selling price at $48/Barrel so it sells 100000 Barrels of crude oil at $48/Barrel so the total contract size is $4800000.
If price falls down on the expiration date, if the price is $45/Barrel then it will be a profit for Crude oil producer.
Profit: $48 - $45 = $3/Barrel
Total profit: 100000 * $3 = $300000
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