7. Suppose in six months\' time the cost of a liter of heating oil will either b

Question

7. Suppose in six months' time the cost of a liter of heating oil will either be $1.70 or $2.30. The current price is S2.00 per liter. a. What are the risk faced by a reseller of heating oil that has a large inventory on hand? What are the risk faced by a large user of heating oil with a very small inventory? b. How can these two parties use the hearing oil futures market to reduce their risks and lock in a price of s2.00 per liter? Assume each contract is for 50,000 liters and they each need to hedge 100,000 liters.

Explanation / Answer

Ans. (a). The risk is defined as the uncertainity about the future events which can result in actual outcome being different from the expected outcome. Risk is used to denote negative uncertainity.

The reseller with a large inventory would be expecting stable or better increase in the future prices which will result in the value of his inventory to increase and result in higher profit for him. However, if the price of heating oil was to decrease from current levels, the reseller's inventory valuation will also decrease and he may be required to sell at lower profit or worse in a loss. This uncertainity regarding the future movement of heating oil prices can impact the bottom line of the reseller with large investory, hence is a potential risk. If the price of heating oil is $ 1.7 and current price is $ 2 - the reseller would have stocked up assuming current price as sale price; hence at oil at $ 1.7 represents potential lower revenues by $ 0.30 per litre and may even result in loss. If we take the date from the question, at 100,000 litres the potential lower revenues can be $ 30,000.

On the other hand, for a large user with small inventory, the risk is that the price of heating oil may increase from current $ 2 to $ 2.3. This will result in significantly higher cost since the inventory is not going to be sufficient to cushion against the increased prices. In numbers, if we assume that the user has requirement for 100,000 litres and assume that the inventory is insignificant, then the cost can potentially increase $ 30,000 which is a risk for the operations of the user.

Ans. (b). Since, both the parties are on the opposite end of the spectrum i.e. the reseller looses if the price goes down and user looses if the price goes up - they can help each other by entering into a futures contract where the reseller can sell 2 lots (50,000 litres each lot), expring at the end of 6 months, to the user at $ 2. This way the sale price for the reseller will be locked in at $ 2 and at the same time the purchase price for the user is also locked in. This locking in of the price at the current levels, removes the uncertainity involved in the price of heating oil at the end of 6 months (we assume that there is no counter party risk for this exposition). Though the reseller, by selling the future, gives up the opportunity of possible higher profits if the price would have moved to $ 2.3, but s/he is also covered against losses which could have occurred if the price would have decreased to $ 1.7.

Similarly, the user also gives up the possible lower cost if the oil price would have moved to $ 1.7 after 6 months for a more certain lock-in price of $ 2 - because this saves it from the loss scenario if the price would have increased to $ 2.3. So we see, that both re-seller and user benefit from this hedge by using the futures to cover for their respective risks.

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