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Fixed Price Contract

Hedging is a way of reducing some of the risk involved in holding an investment. There are many different risks against which one can hedge and many different methods of hedging. When someone mentions hedging, think of insurance. A hedge is just a way of insuring an investment against risk.

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Consider a simple (perhaps the simplest) case. Much of the risk in committing to a fixed price for anything over an extended period is market risk ; i.e. if the market rises sharply, chances are that all of your costs will too. So if you bid a price for haulig materials for the next six months, you may do well to hedge your fuel costs.

There are many ways of hedging against market risk. The simplest, but most expensive method, is to buy a call option for the fuel you expect to purchase. (It’s most expensive because you’re buying insurance not only against market risk but against the risk of the specific security as well.) You can hedge by buying financial futures (e.g. the S&P 500 futures). If fuel prices skyrocket, exercise the option and buy the fuel for the lower price.

If fuel prices drop, purchase the fuel at the lower price and let the option expire worthless.

If you’re trying to hedge an entire portfolio, futures are probably the cheapest way to do so. But keep in mind the following points.

  • The efficiency of the hedge is strongly dependent on your estimate of the correlation between the fuel you plan to purchase and the broad market index.
  • If the market goes down, you may need to advance more margin to cover your long position.
  • If the market moves up, you will not participate in the rally, because by intention, you’ve set up your futures position as a complete hedge.

For Fuel Hedging, Jackson Oil offers a fixed price fuel contract. Considering the points above, Jackson will choose to hedge the risk depending on market conditions and future expectations. For the buyer, this risk is assumed by Jackson and charged in the form of a premium to the current fuel price. However, even though there is a price for the value of the service, this is the truest a purest form of hedge protection for the customer and would be equivalent to buying all of the fuel in advance and storing it. This isn’t very practical for most customers.


Contributed-By: Norbert Schlenker; Modified for fuel by Ron Willis

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