1. ARE 495: Introduction to Commodity Futures Markets Lecture 19: Devising a Real-World Hedging Strategy: Optimal Hedge Ratio (Part 2) Nick Piggott & Wally Thurman NCSU Agricultural & Resource Economics March 21, 2016 11.45 am – 1.00pm Kilgore 125, NCSU

2. Review  WSJ: “Airlines Retreat on Fuel Hedging” 3/21/2016  Devising a hedging strategy  Real-world and real-time problems using real data  The goal here is to teach you skills using standard software packages such as Excel to make more informed risk management strategies and decisions  A hedger faces two critical decisions: 1.What kind of futures to use 2.Which contract month of that futures to use  The hedger in making these choices will be wanting to maximize hedging effectiveness, this means choosing a futures contract with prices that are highly correlated with the underlying cash commodity.

3. Our “Real World” Assignment  You have just been hired by Qantas Airlines to manage their procurement and risk management of jet fuel prices for their new route between DFW and SYD. 1.Jet fuel is a product from crude oil and does not have a futures contract so what contract should we use to cross- hedge the price risk exposure?  Last lecture & Hwk #7 where we found heating oil to be most highly correlated to jet fuel. 2.What is the optimal futures position to assume or alternatively the optimal hedge ratio?  Today’s Lecture

4. Some important details “Qantas relies on a long-range A380 (seats 484 passengers weighs 1.2 million pounds) for the service, which feeds into the Texas hub of One World partner American Airlines to shuttle passengers to destinations in the eastern half of the US. According to Airbus, the extended range A380 has a range of 8,200 nautical miles. This route definitely pushes the envelope at SYD to DFW being 7,451 nautical miles and will take nearly 58,200 gallons of jet fuel to power the aircraft across the Pacific Ocean.”  With fuel mileage of (7,453/58,200)=0.128 nautical miles per gallon “Qantas Flight 7 will depart Sydney six times a week (everyday except Tues)”  WEEKLY FUEL USEAGE: 58,200 gallons ×6 ×2 = 698,400 gallons per week  3/11/2014=Jet Fuel was $2.912 per gallon so $2.034 million per week in Jet Fuel expenses or $105.8 million annually for this one route SYD-DFW Interestingly, currently their most profitable flight

6. Which Futures Contract Should We Use to Cross-Hedge?  The futures contract that is most strongly correlated?  Table 1 reveals there is a relationship between jet fuel prices and all three futures prices, the relationship between jet fuel prices is more correlated with heating oil than the other two. Thus heating oil futures are the best choice with which to cross-hedge jet fuel prices. HWK#7

7. Next Decision is the Optimal Futures Position to Assume or the Optimal Hedge Ratio  How many heating oil contracts will result in the maximum possible reduction in the variability of the total hedged position? THE HEDGER WISHES TO MINIMIZE RISK: TAKE A FUTURES POSITION THAT RESULTS IN THE MAXIMIMUM REDUCTION IN THE VARIABILITY OF THE TOTAL HEDGED POSITION.

8. Some Definitions & Algebra  Hedge ratio (HR) where Q f is the quantity (or units) of the commodity represented by the futures position and Q c is the quantity (or units) of the commodity being hedged.  In our example we need to hedge 698,400 gallons of jet fuel per week using heating oil futures.  There are 42,000 gallons in 1 heating oil (HO) contract.

9. Some Definitions & Algebra…  The HR that minimizes risk is defined as: where is the quantity (or units) of futures that minimize risk.

10. Change in Value of Hedged Position  Consider the following where

11. Change in Value of Hedged Position…  Important properties of the hedge:  are assumed to be constant for the life of the hedge.  If we set the change in the value of the hedged position to zero (making variability equal to zero),

12. Risk Minimizing Quantity of Futures  We have shown that  So it follows that  This result can be used to determine the quantity (or units) of the futures position with which to hedge

13. Change in Value of Hedged Position…  One last detail important detail to deal with where is the number of contracts that minimizes risk, and is the quantity (or units) of the commodity represented by each futures contract for.  in our example for heating oil (HO) there are =42,000 gallons per contract and we know we need gallons of jet fuel per week  Thus  Since we know Q c and Q fc the challenge is to estimate HR*:

14. The Naïve Method  Table 1 provides daily jet fuel prices (col 2) and heating oil (Col 3) for the last month of 2012.  Col 6 shows  Note the value of varies daily its average value is 0.75, implying a hedge ratio HR*= 0.75.  The minimum-variance hedge would be to buy (or be long) a position of 12 heating oil contracts.

15. Regression Method  Another method used to estimate the minimum-variance hedge ratio is regression analysis. Specifically regression methods provide the best linear unbiased estimate (BLUE).  Regression involves estimating the following equation for the time series of price changes: where

16. Regression Method…  The summary output provides a regression of the changes in daily jet fuel prices and heating oil prices for the last month of 2012.  Note the value of  provides the estimate of HR*, implying a hedge ratio 0.857.  The minimum-variance hedge would be to buy (or be long) a position of 14 heating oil contracts.

17. HWK #8: Calculate Optimal Hedge Ratio ( Due 3/23/2016 at start of class )  Using the dataset provided on class website (http://www4.ncsu.edu/~wthurman/are495/) in file “Jet_Fuel_Hw7.xlsx” and using the sheet “dataset”:http://www4.ncsu.edu/~wthurman/are495/ 1.Estimate the optimal hedge ratio (HR*) over the period 2013 (1/2/2013-12/31/2013) using the naïve method and calculate the optimal number of heating oil contracts that should be purchased (taking a long position) to hedge one week of jet fuel for Qantas flight SYD-DFW which requires 698,400 gallons 2.Repeat the same calculation in (1) but instead using regression analysis. There are many sites and videos to show how to do regression in excel just by using the Excel help or google. For example:  How to add in data analysis  https://www.youtube.com/watch?v=nfv1z2ko6jk https://www.youtube.com/watch?v=nfv1z2ko6jk  http://www.excel-easy.com/data-analysis/analysis-toolpak.html http://www.excel-easy.com/data-analysis/analysis-toolpak.html  How to do a regression  https://www.youtube.com/watch?v=TkiB1xBnjn4 https://www.youtube.com/watch?v=TkiB1xBnjn4  http://www.excel-easy.com/examples/regression.html http://www.excel-easy.com/examples/regression.html

18. HWK #8: Calculate Optimal Hedge Ratio… That is, estimate the optimal hedge ratio (HR*) over the period 2013 (1/2/2013-12/31/2013) using regression analysis calculate the optimal number of heating oil contracts that should be purchased (taking a long position) to hedge one week of jet fuel for Qantas flight SYD-DFW which requires 698,400 gallons For (1/2/2013-12/31/2013) regress: