Question

“Today” is late March. Your company, Mesquite Bush Refining Inc., produces 42,000,000 gallons of ultra low sulfur diesel (ULSD) fuel at the end of each month. You have the following market data.

• Spot price of ULSD diesel fuel: S₀ = $1.79/gal.
• Futures price of June NYMEX New York Harbor ULSD futures: F₀ = $2.10/gal.
• Size of the underlying for this futures contract: 42,000 gallons
• Trading in a NYMEX New York Harbor ULSD contract ceases shortly before the contract month begins. For this analysis, assume that time to expiration of the June contract (more precisely, time until the start of the delivery month) is T = 2/12 year.
• Your storage cost for ULSD diesel is $0.125 per barrel per month. Assume that you must pay in advance.
• Continuously compounded one-month risk-free rate: r = 2% per year.

Given current spot and futures prices, should your company hedge its late May sale with ULSD futures? If yes, what hedging strategy should you adopt? (Assume that your company is willing to hedge only at a “fair” price or better.)

Group of answer choices

Hedge: take a short position in 1,000 June ULSD futures contracts. Close out your futures position in late May.

Hedge: take a long position in 100 May ULSD futures contracts. Close out your futures position in late May.

Do not hedge with USLD futures.

Hedge: take a short position in 100 May ULSD futures contracts. Close out your futures position in late May.

Hedge: take a long position in 1,000 June ULSD futures contracts. Close out your futures position in late May.

Answer 1

The no arbitrage future price is given by:

F=So * e^(rt) + future value of storage cost per gallon

= 1.79*e^(0.02*2/12) + 0.125/42 * e^(0.02*2/12) + + 0.125/42 * e^(0.02*1/12) = 1.80 (As the storage cost is paid in advance, we have to take the future value for 2 months for first advance and future value of 1 month for second advance). Also storage cost is given per barrel. We need the price of contract in gallons. Therefore divided by 42.

1 barrel = 42 gallons

Since the June contract is trading richer than theoretical futures price, the company should hedge by going short 1000 June contracts. Each contract is for 42000 gallons and it has an exposure of 42000000 gallons. Also side should be short as the risk to the company is if crude prices head lower.

Since the market is in contango, the company will enjoy a positive roll yield.

The first option is therefore correct