Overview of Derivatives Market
The overall assessment mainly provides a gist of global derivatives market that is currently present within the global market. In today’s context there are different layers of contracts and instrument, which is used by investors, bankers, institutions, security fund and other traders to hedge the risk and increase profits from investment. Without the use of hedging investors are not able to reduce the risk attributes and increase returns from investment. Currently the hedging of crude oil is a necessary requirement for all companies falling under fuel and airline industry. The rising or declining cost of crude oil effect operation capability of both fuel and allied industries. Consequently, the use future and forward contracts to hedge their relevant risk from investment. forward and future contracts are relative instrument that allows the companies to reduce the exposure of volatile prices and fix their expenses. Future and forward contract are useful in hedging the risk of rising prices, which might occur due to the instability in supply of crude oil (Bartram 2017). The main aim of fuel and airline industry is to reduce the cost of acquiring oil and increase the profits in the operations. However, the fuel industry has a contrary view from Airline industry, as they prefer rising crude oil prices for increasing the profits. On the other hand, airline industry needs low-cost fuels to generate high revenues and reduced their expenses for cash outflow. Therefore, both the industries can use forward and future contracts for reducing the risk from volatile crude oil prices.
Currently there are 4 different types of derivatives that is used by Jet fuel trader’s aniline companies for hedging their fuel prices. These different types of derivatives relatively help in reducing of curbing the high risk involved in prices of fuel.
Purchasing current oil contracts:
Purchasing call contacts option is relatively used by airline companies when they believe that prices will relatively rise in future. This could eventually help in reducing the risk from high oil prices, which might hamper their profitability. This type of hedging process relatively allows airline companies to mitigate the risk from rising future prices by purchasing large amounts of current oil contracts, which could be used over the period of 12 months. The process requires high exposure of risk from volatile oil prices, which needs to be conducted thoroughly and with adequate research. Without adequate research the method of purchasing or hedging the current oil market might hamper profitability and expenses of the company (Cifarelli and Paladino 2015). The main aim of the process is to hedge airline companies against rising oil prices.
Different types of derivatives used by jet fuel traders and airline companies
Purchasing Call Options:
The second hedging method that is used by airline companies are purchasing call options, which relatively helps in fixing the specific price for the commodity at a particular date range. This relatively helps the airline companies to hedge against the rising oil prices that might incur during their trade sphere. The call option relatively fixes the price of a commodity on certain range, which airline company is willing to pay after completion of the contract. During this period any incline in prices of crude oil would have immensely benefited the airline companies by reducing their expenses, which increases their profitability from operations. However, Afza and Alam (2015) argued that call option is a relatively beneficial for the company to fix the price, while they lose money when oil prices go below the strike price.
Implementing a Collar Hedge:
Airline companies are also implementing a collar hedge, which allows them to hedge against the rising or declining prices of crude oil. The collar hedge contract mainly uses both call option and put option, which helps during the uncertain future prices. Therefore, the airline company would eventually conduct both call option and put option at the same time which helps to buy and sell stocks at a certain date. This measure mainly Hedges the current position of airline company and maintains the same level of cost incurred for operations during which the trade is conducted. The collar hedge contract is relatively used by airline companies when there is no estimation of rejection of price direction or Trend (Huang and Zhang 2015).
Purchasing Swap Contracts:
The last and powerful hedging measure that is used by airline companies are purchasing of swap contracts, which helps them to use swap strategy for reducing the fuel cost. Moreover, the swap strategy is relatively similar to call options but have more stringent guidelines which allows the airline companies to reduce the risk of rising prices. for the more the swap contracts allow airline companies to purchase the oil contract without having the right or obligation for delivery. The swap contracts provide airline companies with high leverage for the trade, which allows them to benefit from rising or declining prices (Ghosh, Arize and Ghosh 2015). The swap contracts are highly volatile, where the risk of declining prices is relatively enormous, which could hamper actual profitability and cash availability of the airline companies.
Strategy used by Delta:
The strategy used by Delta before the involvement of Jon Ruggles mainly increased losses for the organization, which hampered their actual profit. The Hedge Fund maintained by the company was not provide adequate support to their operations for reducing the excessive losses from fuel prices. However, after the involvement of Jon Ruggles in the operations of Delta, the organization was able to increase substantial income from their aging activities. furthermore, the robust strategies used by Jon Ruggles allowed Delta to support their expenses on high fuel prices and generate adequate income for the shareholders. the main problem started during the winter holidays, where Jon Ruggles bet that crude oil prices would be in the range of $105 to $125. This trade conducted by Jon Ruggles was the biggest mistake for Delta Corporation, as after sometime the crude oil prices declined to $100, due to excessive supply and low demand. this trending crude oil prices was not accurately estimated by Jon Ruggles, which increased losses for the organization. The second biggest mistake conducted by Delta Corporation was ignoring the advice of Jon Ruggles for not conducting further trades on crude oil (Knittel and Pindyck 2016).
Purchasing current oil contracts
Hence, by ignoring the advice managers of delta Corporation hedged their position for $100 by using swaps or private contacts. This purchase of not advisable swaps increased the losses of the organization, as crude oil prices double down to $88. The main problem started when Jon Ruggles ignored the information provided by Goldman Sachs in regards with the trades conducted for Delta corp. Jon Ruggles used heating oil for the trades, which was not needed by the organization in the current operational capability. Ignorance of senior management also played a major role in declining the actual profits and hampering the stability of Delta corp (Ekeland, Lautier and Villeneuve 2017).
Strategy used by China Aviation Oil (Singapore) Corporation Ltd:
From the evaluation of the case study for China aviation Oil Corporation Limited, relevant strategies that was used by the organization was considered faulty. The main problem started when China aviation Oil Corporation conducted speculative option trades to increase their profits from the rising Trend. This relevant increment of speculative option trading increased risk attributes of the company, while raising the level of Investments in the open market. The problems for the organization started from 4th quarter when estimated price conducted by the show was not achieved at the end of 2003. Moreover, in 2004 the price increased $38 per barrel, which was used as the value for short position conducted by China Aviation Oil Corporation Limited. The open short position of the organization relatively accumulated loss of $390 million and unrealized loss of $160 million in derivatives. This relatively brought the overall derivatives loss to $550 million over the trading period. the use of speculative trading resulted in the problems, which was faced by China Aviation Oil Corporation Limited (Till 2014).
Further problems identified by Price Water House Coopers, where they pointed out the specific problems evaluation of the derivative trading conducted by the organization. The key problem was regarding the fair value and intrinsic value of derivatives that was needed during the progress of the trade. China aviation Oil Corporation Limited relatively used fair value of an option instead of intrinsic value, which derived the actual derivative value in their books. Lastly it was also evaluated by PWC that CEO of China aviation Oil Corporation Limited instead of closing the losing trades was compensating them by collecting premiums on options that had the potential to generate future losses. This escalated problems for the organization and ended their monopoly in the market (I. Ivanov 2014).
Purchasing Call Options
Evaluation of case study it could be identified that derivatives a kind of time bomb which needs to be dealt with extra precautions. this time bomb could eventually hamper profitability and operational feasibility of the companies or investors if it’s not used adequately. Furthermore, the statement no hedge is better than hedge is not true, as many multinational companies and investors are using the method to reduce their exposure to volatility. The current scenario of the financial market is relatively immense, which needs adequate planning and researching before making any kind of decision. Moreover, the limited resources with changing demand and supply relatively alters the price of a particular product. this volatility in prices of shares, currency, and commodity needs to be reduced with the help of adequate instruments. In this context, Chan et al. (2015) mentioned that with the help of derivative contracts companies Are investors can used one-to-ten ratio for that trades without even realizing the actual goods in future.
The derivative instrument was mainly built for multinational companies, hedge fund manager and big firms that have high exposure in currency and capital market. This instrument mainly reduced the excessive burden on capital requirement and Allowed companies to adequately hedge their position against volatile price. The main problem started when individual investors and any no wise person was using the derivative instrument for their speculative trades, as instrument provided adequate leverage for speculation conducted by investors. The investors could use the instrument without even paying the actual amount of the trade, as it is not required in derivatives. The capital blockage in derivatives is minimal where investors or companies need to provide one tenth of the investment capital as their Margin Call to help them continue with the trade.
One of the major failures of derivative instrument can be identified from the financial crisis of 2008, where silicon swaps were used conductive trades in the ratio 1/20. This indicates that the underlying value of the asset is relatively lower than the actual market cap in which it was trading. Therefore, hedge is a relative instrument that can be used for good and not for speculative trades conducted by investors of companies. Hedge, if conducted adequately could allow companies to minimize the risk from volatile capital market and currency market, which enables them to reduce the losses incurred in financial operations. Hence, hedging is the best policy for companies and investors, while no hedge would drastically increase their risk exposure (Lin and Cong 2017).
Implementing a Collar Hedge
Using adequate control measures companies might protect themselves against wrong use of derivative transactions, which could help them reduce the losses incurred from the trade. The following measures can be used by the companies.
Thorough research and monitoring:
Thorough Research and monitoring process can be used by the company before and after initiating the relevant derivative transactions. before the transaction relevant research regarding the derivative and its requirement for the company needs to be conducted. This investigation would eventually allow the organization to detect the viable underlying value of the assets that is being traded. Furthermore, the derivative transactions would eventually help in conducting hedge transactions which might reduce the risk from volatile capital market. After completing the relevant research and initiating the derivative contract the company needs to conduct relevant monitoring of the trade. This relevant monitoring process would eventually allow the organization to reduced losses from the wrong trades that is being taken. the modern process also helps in identifying any kind of change in Trend, which might hamper actual profitability of the company (Hull and Basu 2016).
Non-speculative trades:
Company’s needs to use non-speculative trades for conducting the hedging process as by using speculative trades companies increase the risk exposure in the market. The reduction in non-speculative trades, which was conducted by both the companies depicted in the case study could eventually help normal companies to reduce the losses from wrong trend. Therefore, trades that are needed by the company needs to be conducted with the help of derivative instrument by evaluating the underlying value of the assets (Park and Abruzzo 2016).
Using different hedging methods:
Lastly, the company could use different hedging methods for reducing their risk from investment such as options, forward contracts, and future contracts. The use of different types of contracts could eventually help the companies to reduce the risk from capital and currency market. The different components of the contract are beneficial for the company where the selection of adequate trading instrument would eventually reduce the risk and increase return attributes of the organization. The four companies by evaluating the current position in the market could use the derivative instruments for curbing the risk from volatile markets. The trade in currency and commodity market need to be conducted with adequate hedging methods to reduce companies risk exposure (Mellios, Six and Lai 2016).
Conclusion:
The assessment mainly aims in identifying the use of hedging and evaluating two different types of cases, which could depict the usefulness and harmfulness of derivative contracts. Furthermore, the use of hedging is identified in the assessment, which could allow fuel and airline industry to effectively improve its income by reducing the expenses on high crude oil price. Moreover, the problems in they both the two cases are evaluated, which indicates that with adequate monitoring and evaluation both the companies would have reduced the losses due to the changing crude oil prices. The non-capability of both the companies in grasping the trend of crude oil was the major problem that was detected from the case study. However, the continuous persistence of the companies in making different swaps and trades for reducing the losses mainly escalated the problem, which could have been contained. The rising problems of speculative trades conducted with the help of hedging needs to be controlled by companies to reduce their overall bad trades. Therefore, with the use of adequate control and monitoring measures, the companies could reduce the risk from hedging and effectively curb their risk from currency and capital market.
Reference and Bibliography:
Afza, T. and Alam, A., 2015. Foreign Currency Derivatives: Hedging or Speculation. Vidyabharati International Interdisciplinary Research Journal, 3(2), pp.24-34.
Ames, M., Bagnarosa, G., Peters, G.W., Shevchenko, P.V. and Matsui, T., 2016. Which Risk Factors Drive Oil Futures Price Curves? Speculation and Hedging in the Short and Long-Term.
Bartram, S.M., 2017. Corporate hedging and speculation with derivatives. Journal of Corporate Finance.
Berta, N., Gautherat, E. and Gun, O., 2017. Transactions in the European carbon market: a bubble of compliance in a whirlpool of speculation. Cambridge Journal of Economics, 41(2), pp.575-593.
Chan, L.H., Nguyen, C.M. and Chan, K.C., 2015. A new approach to measure speculation in the oil futures market and some policy implications. Energy Policy, 86, pp.133-141.
Cifarelli, G. and Paladino, G., 2015. A dynamic model of hedging and speculation in the commodity futures markets. Journal of Financial Markets, 25, pp.1-15.
Ekeland, I., Lautier, D. and Villeneuve, B., 2017. Hedging pressure and speculation in commodity markets.
Ghosh, D.K., Arize, A. and Ghosh, D., 2015. Trades in commodities, financial assets, and currencies: A triangle of arbitrage, hedging and speculative designs. Global Finance Journal, 28, pp.1-9.
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