Group Size and Group Management:
The maximum group size is 4 students. You may choose to submit individually. Groups may consist of students from both streams. Please enrol in the group of your choice through the LMS à Groups page. There is a topic on the LMS Discussion Board serving as a marketplace for students looking to join a group and for groups searching for additional members. There will be no assignment of students to groups by the subject coordinator.
It is expected that all members of a group will make an equitable contribution to the completion of the project and on this basis, it is expected that all group members will receive the same mark. Management of your group is your responsibility. I recommend you establish norms and procedures for working effectively early and deal with any problems that arise early. If some members of a group inform me that a member of their group has not contributed equitably, then I will assign the marks within that group appropriately. An appropriate outcome may involve different students in the one group receiving different marks and those different marks can mean that a freeloader receives zero marks.
Each group’s solution is to be the work of members of that group only. No questions about this project may be asked of the lecturers in the subject. If the project is unclear, then discuss it within your group. If you find that you need to make an assumption, then do so and include and justify your assumption as part of your solution.
Due Date and Submission:
The project is due on 9 October 2020.
The project is to be submitted using the Assignment Tool of the subject’s LMS website.
Your answer must be typed and should not be longer than 12 pages. I stop reading after 12 pages.
Do not include any spreadsheets in your answer.
You are required to keep a copy of your assignment after it has been submitted as you must be able to produce a copy of your assignment at the request of teaching staff at any time after the submission due date.
Carry out all calculations to four decimal places. Express all dollar answers to the nearest cent. Express all answers related to the number of future contracts to the nearest whole number.
HEDGING QANTAS’ AVIATION FUEL COSTS
The project examines the trades in futures contracts that Qantas might make if Qantas wishes to hedge its aviation fuel costs over a coming year.
A recent Qantas financial report states:
Fuel price risk: The Qantas Group uses options and swaps on aviation fuel and crude oil to hedge the exposure to movements in the price of aviation fuel. Hedging is conducted in accordance with Qantas Group policy. Up to 100 per cent of estimated fuel costs out to 12 months may be hedged and up to 50 per cent in the subsequent 12 months, with any hedging outside these parameters requiring approval by the Board of Directors. During the year, the net loss from fuel hedging was $75.9 million.
The report also states that fuel costs for the prior year were AU$1,570,000,000. Since aviation fuel averaged around AU$1 per gallon that year, we will assume that Qantas uses around 1,570,000,000 gallons of aviation fuel over a year.
Assume that it is currently the end of 2002. Qantas’s plan for acquiring the aviation fuel it will use during 2003 is
- to immediately purchase and store until required the aviation fuel needed for the coming quarter (i.e. to immediately purchase 392,500,000 gallons = ¼ × 1,570,000,000 gallons), plus
- at the end of March purchase and store an additional 392,500,000 gallons of aviation fuel, plus
- at the end of June purchase and store a further 392,500,000 gallons, plus
- at the end of September purchase and store the remaining 392,500,000 gallons.
Consider a plan to hedge the March-end, June-end and September-end acquisition costs by trading in futures on oil products. You are asked to investigate hedging by trading in either the gasoline futures or the crude oil futures traded on the New York Mercantile Exchange (NYMEX). Gasoline futures and crude oil futures are quoted in US dollars (US$). Qantas is interested in determining the best possible hedge using either one or the other of these two contracts. Each crude oil futures contract covers 1,000 barrels. Crude oil futures are quoted as a price per barrel and the price per crude oil futures contract is 1,000 × crude oil futures price per barrel. Each gasoline futures contract covers 42,000 gallons and the price per gasoline futures contract is 42,000 × gasoline futures price per gallon.
For simplicity, ignore the mark-to-market feature of futures contract: If you buy a contract on 31/12/2002 and sell it on 31/3/2003, then assume for simplicity that your gain or lose is realized on 31/3/2003 and is equal to the change in the futures price over the three months.
Assume that to hedge its end-of-March aviation fuel purchase costs, Qantas takes a position on 31/12/2002 in futures contracts that mature in mid-June; i.e., that mature after March. When Qantas buys spot aviation fuel at the end of March so that it has enough fuel in its storage facilities to cover its fuel needs over the April through June quarter, Qantas will close out its position in the futures that mature in mid-June. Similarly, assume that to hedge the cost associated with its end-of-June spot purchases of aviation fuel, Qantas takes a position on 31/12/2002 in futures contracts that mature in mid-September and closes out that futures position at the end of June when it purchases aviation fuel to store and use during the third quarter of the year. Finally, assume that to hedge its end-of-September purchases, Qantas takes a position on 31/12/2002 in futures contracts that mature in mid-December and closes out that futures position at the end of September.
The Excel file Futures Hedging Project.xls contains 3 worksheets: March Prices, June Prices, and September Prices.
March Prices: For each year from 1987 through 2003 inclusive, this worksheet contains:
- March-end aviation fuel prices in US$ per gallon;
- March-end quoted prices of NYMEX gasoline futures contract maturing in mid-June—the prices are quoted in US$ per gallon; and
- March-end quoted prices of NYMEX crude oil futures contract that matures in mid-June—the prices are quoted in US$ per barrel.
Consider the first row of the file titled March Prices: At the end of March 1987, aviation fuel cost US$0.4821 per gallon. At the end of March 1987, the futures price of a gasoline futures contract maturing in mid-June of 1987 was US$0.5417 per gallon. At the end of March 1987, the futures price of a gasoline futures contract maturing in mid-June of that year was US$18.53 per barrel.
June Prices: For each year from 1987 through 2003 inclusive, this worksheet contains:
- June-end aviation fuel prices in US$ per gallon;
- June-end quoted prices of NYMEX gasoline futures contract that matures in mid-September; and
- June-end quoted prices of NYMEX crude oil futures contract that matures in mid-September.
September Prices: For each year from 1987 through 2003 inclusive, this worksheet contains:
- September-end aviation fuel prices in US$ per gallon;
- September-end quoted prices of NYMEX gasoline futures contract that matures in mid-December; and
(iii)September-end quoted prices of NYMEX crude oil futures contract that matures in mid-December.
- Use the 1987 through 2002 data in the March Prices worksheet to determine an answer to the following question: If you were to establish a futures hedge on 31/12/20002 in an attempt to hedge the US$ cost of Qantas’ March 2003 aviation fuel purchases by trading in only one of the gas or the crude futures contracts maturing in mid-June, then (1) which contract would you trade and why, and (2) how many contracts of the chosen type would you trade?
- Now consider hedging the US$ cost of Qantas’s June-end 2003 aviation fuel purchases by establishing a position on 31/12/2002 in futures that mature in midSeptember. Use the 1987 through 2002 data in the June Prices worksheet to determine (1) whether it would be better to hedge with gas or crude futures contracts that mature in September and (2) how many contracts of the chosen type would you trade?
- Now consider hedging the US$ cost of Qantas’s September-end 2003 aviation fuel purchases by establishing a position on 31/12/2002 in futures that mature in mid-December. Use the 1987 through 2002 data in the September Prices worksheet to determine (1) whether it would be better to hedge with gas or crude futures contracts that mature in December and (2) how many contracts of the chosen type would you trade?
- On 31/12/2002, the US$ futures prices for gas and crude oil contracts with various maturities in 2003 were:
|June 2003 maturity futures||Sep. 2003 maturity futures||Dec. 2003 maturity futures|
What would have been the aggregate gain or loss in calendar year 2003 from the positions in the various futures contracts that you established on 31/12/2002?
- If your futures trades produced a loss, then explain clearly why this is not evidence of a lack of hedging expertise on your part.
- If instead your futures trades strategy produced a gain, explain clearly why this is not a signal you should be managing a futures trading desk.
You should only be answering one of subparts (i) and (ii) of this question. Your answer to part (d) should be no more than half a page.
- On 31/12/2002 the spot price of aviation fuel was US$0.7214 per gallon. Take this value as the market’s expectation on 31/12/2002 of the future spot price of aviation fuel on each of 31/3/2003, 30/6/2003, and 29/9/2003. What would have been the total realized deviation of the unhedged cost of acquiring Qantas’s aviation fuel needs in March, June and September from this expected cost? If Qantas had implemented your optimal hedge, what would have been the total realized deviation of the hedged cost from the expected cost in the absence of the hedge?
- In practice, Qantas uses both options and futures to hedge. What are the benefits and costs of using options rather than futures to hedge the cost of Qantas’s aviation fuel purchases in 2003? 1 page maximum on part (f).
- Comment on the desirability of a goal of trading futures in order to minimize the variability of the cost of acquiring aviation fuel. Your answer should consider:
- The relation between Qantas’ profits and aviation fuel prices. Note that if aviation fuel costs do increase, then Qantas and its competitors might increase ticket prices.
- The nature of competition in the airline industry. Note that if Qantas locksin its aviation fuel costs and Singapore Airline chooses not to hedge, then one airline will have a competitive advantage if aviation prices then rise while the other will have an advantage if instead aviation fuel prices fall. iii. Whether Qantas’ shareholders do or do not benefit from a reduction in variance risk. Consider the relation between variance risk and systematic risk as well as shareholders’ ability to diversify away non-systematic risk.
2 pages maximum on part (g).
- Suppose Qantas could come close to locking-in the US$ cost of its future aviation fuel needs by hedging using NYMEX futures. What additional futures trades would Qantas have to make in order to lock-in the Australian$ cost of acquiring its 2003 aviation fuel needs. A numerical answer to part (h) is not required.
1 page maximum on part (h).
- In this part you will need to think about hedging a spot position by trading in two different futures contracts. More of the variation in aviation fuel prices can be explained by what is happening in both the gasoline and crude oil markets than by what is happening in only one of the two markets. Consider again the data in the March Prices worksheet and again consider hedging the US$ cost of acquiring 392,500,000 gallons of aviation fuel on 31/3/2003. Assume now that you are not limited to trading in only one of the gasoline and crude oil futures contracts. Rather, you can trade in both contracts at the same time. What are the optimal positions to simultaneously take on 31/12/2002 in the two types of futures contracts if your goal is to minimize the variance of the cash flow associated with buying aviation fuel at the end of March while simultaneously closing out your positions in the mid-June maturity gasoline and crude oil futures contracts? In particular, how many of each contract will you trade and will you take long or short positions in each futures contract? Briefly explain you answer.