Hedging : case study

BFF5977 Individual Assignment –

 

Submission: Submit electronically via Moodle

 

Weight Assigned: 20 %

 

 

1.    Instructions

 

  1. This is an individual assignment.

 

  1. This assessment is designed to test your achievement of Objectives 1 to 5 as detailed in the Unit Outline.

 

  1. The maximum word limit for this assignment is 2,500 words with a 10% allowance (2,750 words). The word count includes: the Title Page, Executive Summary (if you choose to include one – this is not mandatory), body of the report and all Appendices. The Bibliography, Table of Contents, figures and tables are excluded from the word count limit. Please include a word count on the cover page.

 

  1. The assignment will be marked out of a total of 100 marks, and will count toward 20% of the total marks for this Unit.

 

  1. Work submitted for assessment must be accompanied by a completed and signed assignment coversheet.

 

  1. The assignment must be submitted via Moodle by the due date and time. Submission will be subject to Turnitin. Please note penalties will apply to late submissions. A penalty of 5% of the total mark allocated to this assessment task will be deducted for each day, or part thereof, if it is late. Multiple submissions are permitted up to the due date and time.

 

  1. Work submitted for assessment must be consistent with the guidelines set down in the Q Manual, which is the faculty’s student guide for producing quality work on time. Copies of this manual can be purchased at the bookshop or accessed online at:

http://www.buseco.monash.edu.au/qmanual/qmanual.pdf

 

Marks may be deducted where in-text citations and/or the reference list is not consistent with the American Psychological Association (APA) style, which is illustrated in the Q Manual.

 

 

  1. Tasks to be completed

 

PART 1: (40 marks)

 

 “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

 

Berkshire Hathaway Inc. Chairman of the Board Warren Buffet, “Letter to the Shareholders of

Berkshire Hathaway Inc.,” February 21, 2003

 

Since the early 1990’s, there have been a number of high profile businesses that have realised huge losses associated with the use of derivatives for hedging that went wrong.

Better known cases in the 1990’s involved Barings Bank (195), Long Term Capital Management (1998), Procter and Gamble (1994), Metallgesellschaft AG (1993), and Orange County California (1993) whilst more recent cases include JP Morgan (2012), AIG (2008) and China Aviation Oil (2004).

 

You are required to choose one of the above cases. In relation to your chosen case, answer the following questions:

 

  • Describe the facts, including background (nature of company business, trading history, size, etc.) and nature and amount of losses realised;
  • Explain the risk that the company was subject to and detail Risk Management (RM) techniques that were used. Please note any specific derivatives hedging strategy.
  • Explain what went wrong in detail;
  • Evaluate the RM performance; and detail any lessons learned from the experience.

 

PART 2: (60 marks)

 

Choose one of the following two cases and answer the questions relating to your case of choice. Case readings are available from Moodle. You are encouraged to conduct your own extra research to answer the questions.

 

CASE 1: HEDGING AT PORSCHE

Porsche, a German manufacturer of performance cars, was known for a cautious approach to risk management and conservative financial policies. In 2007, however, it stunned analysts and investors by reporting billions of dollars of profits from transactions on financial derivatives. Some of these profits came from foreign exchange hedging, but much of them were due from a huge position in options on Volkswagen stocks. Volkswagen, one of the world’s largest car manufacturers and a company many times the size of Porsche, was partnering with Porsche on a number of development and manufacturing projects.

Porsche used the option to build an ownership stake in Volkswagen. Porsche argued that the ownership stake was necessary to prevent a hostile takeover and breakup of its key partner by a third party. Porsche’s executives further maintained that the options strategy to build the stake was prudent because it protected Porsche against the risk of a substantial rise in Volkswagen’s stock price once Porsche’s intentions became clear to market participants. However, critics argued that Porsche’s derivatives transactions represented reckless speculation that could put the entire company at risk.

 

Answer the following questions relating to the case.

  • Should Porsche hedge its foreign exchange exposure? How do Porsche competitors, such as BMW, deal with this risk? Can Porsche do something similar?
  • Research Porsche’s option hedging strategy and describe it in detail. What would be an alternative hedging strategy? Which strategy is better for Porsche?
  • How did Porsche build its Volkswagen stake? Why not buy Volkswagen stocks directly?
  • Was Porsche’s attempt to build a stake in Volkswagen a sensible one? Or do you agree with critics who argued that Porsche was speculating with shareholders’ money and it had become a hedge fund that neglected its core business? Justify your answer.

 

CASE 2: FUEL HEDGING AT JETBLUE AIRWAYS

Traditionally, airlines cross-hedge their jet fuel price risk using derivatives contract on other oil products such as WTI and Brent crude oil. Consequently, an airline is exposed to basis risk due to asset mismatch.

Please use the case “2010 Fuel Hedging at JetBlue Airways” (available for download from Moodle) and your extra research to answer the following questions.

  • Should JetBlue Airways hedge its fuel price risk? Compare and contrast JetBlue’s approach to managing its fuel price risk to other US airlines.
  • Given the high price of jet fuel at the end of 2011, should JetBlue hedge its fuel costs for 2012? And, if so, should it increase or decrease the percentage hedged for 2012?
  • Explain the concept of cross-hedging and the basis risk that results from cross-hedging. Should JetBlue continue using WTI as an oil benchmark for its crude oil hedges or switch to Brent? Justify your answer using the provided data.
  • What alternative Risk Management techniques could JetBlue Airways have used?