Hedge Agreement

Airlines use futures and derivatives to ensure their commitment to jet fuel prices. They know they have to buy jet fuel for as long as they want to stay in business, and fuel prices are notoriously volatile. The use of crude oil futures contracts to meet their fuel needs (and participation in similar but more complex derivatives transactions) has saved Southwest Airlines a lot of money on fuel purchases compared to competing airlines, while U.S. fuel prices have risen dramatically after the Iraq War in 2003 and Hurricane Katrina. A differential contract (CFD) is a bilateral security or swap contract that allows the seller and buyer to set the price of a volatile product. Consider an agreement between an electricity producer and an electricity distributor, both of which operate through an electricity market pool. If the manufacturer and retailer accept a strike price of $50 per MWh for 1 MWh during an exchange period and the actual pool price is $70, the producer will receive $70 from the pool, but will have to pay $20 (the “difference” between the strike price and the pool price) to the retailer. For many complexities of the procedure, it is not advisable to reach an agreement without the advice of an expert. The specific hedging strategy and pricing of hedging instruments will likely depend on the downside risk of the underlying guarantee against which the investor wishes to protect himself.

In general, the higher the downside risk, the higher the cost of coverage. The downside risk tends to increase with higher volatility and over time; An option that expires after a longer period of time and comes with a more volatile warranty becomes more expensive as a means of protection. In the stock example above, the higher the strike price, the more expensive the put option becomes, but the more price protection it offers. These variables can be adjusted to create a less expensive option that offers less protection, or a more expensive one that offers greater protection. However, at some point, it is not advisable to buy additional price protection from a cost-effectiveness perspective. Investors who mainly contract futures can guarantee their futures contracts against synthetic futures. In this case, a synthetic is a synthetic future including a call position and a put position.

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