Business, 06.05.2020 04:06 mairealexander87

On January 1, 2015, the spot price for a barrel of Texas Crude is $ 50.00 per barrel. Drysdale Financial is a financial institution currently offering eighteen-month derivative oil contracts, each denominated in 100,000 barrels of oil. These contracts may be settled at any time prior to June 30, 2018, but must be settled on that date if they had not been closed previously. (Denote "SP" as the spot price of oil on the date a contract is settled.)

Party A receives: 100,000 x ($50 – SP) per contract if SP < $ 50 on the date the contract is settled

Party A pays: 100,000 x (SP - $50) per contract if SP > $50 on the date the contract is settled

Party B will have the exact opposite cash flows as Party A. Air Jethro may elect to take the position of Party A or Party B, with Drysdale Financial serving as the counterparty. (While Drysdale Financial would ordinarily charge a fee for accepting this type of contract, this fee is ignored for purposes of this problem.)

For purposes of the following problems, assume that the spot price of oil on December 31, 2015 is $ 40.00 per barrel and that the spot price of oil on June 30, 2016 is $ 35.00 per barrel. (Note that these amounts are not known on January 1, 2015, and only become known as time passes.)

Assume that Air Jethro purchases 250,000 barrels of oil from Clampett Oil on January 1, 2017 at a price of $ 50.00 per barrel. Further, assume that on January 1, 2017, Air Jethro also enters into three oil derivative contracts with Drysdale Financial, and designates the contracts as "fair value hedges".

First Question: In order to create a fair value hedge, should Air Jethro take the position of Party A or Party B in the contract with Drysdale Financial?

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