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Mutual benefit of hedge transaction

Suppose in six months' time the cost of a gallon of heating oil will either be $0.90 or $1.10. The current price is $1.00 per gallon.


a) What are the risks faced by a reseller of heating oil that has a large inventory on hand? what are the risks faced by a large user of heating oil with a very small inventory?

b) How can these two parties use the heating oil futures market to reduce their risks and lock in a price of $1.00 per gallon? Assume each contract is for 50,000 gallons and they each need to hedge 100,000 gallons.

c) Can you say that each party has been made better off? Why or why not?

Solution Preview

a) The reseller who is sitting on a large inventory of oil fears that the oil price will drop to $0.90. If it does it will incur a loss of $0.1 per gallon. The user of heating oil who has very little inventory ...

Solution Summary

The solution goes into a great amount of detail related to hedge transactions. The response does an very good job of responding to the questions being asked and provide clear and concise answers to the problem. This is a great response for students looking to better understand the benefit of hedging. Overall, an excellent response.