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Choosing a Cross-Hedge Direction for an Airline’s Jet Fuel Purchase

Article Quant Q&A · Author: user010010001
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Summary

An airline expects to buy jet fuel later and uses heating oil futures to reduce the risk that fuel prices rise before the purchase. Because the airline is exposed to higher costs if jet fuel rises, it takes a long position in the positively correlated futures contract: gains in the hedge may offset the increased purchase cost. A short position would tend to compound that exposure instead of reducing it.

The explanation focuses on the direction of the hedge and assumes positive correlation between the spot price of jet fuel and the futures price. The question also supplies relative variance and correlation information, which would matter when estimating the hedge size, but the answer does not calculate a hedge ratio or discuss how imperfect correlation leaves residual risk. The cross hedge can therefore protect margins only approximately, and its effectiveness depends on how closely the two prices move together over the hedging period.

Key ideas

  • A future buyer of jet fuel is exposed to prices rising before the purchase.
  • A long position in positively correlated heating oil futures can offset part of that cost risk.
  • Cross-hedging leaves residual exposure because jet fuel and heating oil prices may not move in lockstep.
  • Variance and correlation information can help determine hedge size, but the document only explains hedge direction.

Tags

CommoditiesFuturesRisk managementPosition sizing
Full text
# Am I in a long or short position in this case? (Cross hedging)


# Am I in a long or short position in this case? (Cross hedging)












An airline expects to purchase 2 million gallons of jet fuel in 1 month and decides to use heating oil futures for hedging.

The variance of the heating oil futures price is 1,5 times bigger then the variance of the price of the jet fuel. The correlation between the spot jet fuel price and the 3 month heating oil futures price is 0.5.

Question a) Does the airline take a long or a short position in the futures contract?

Am in long or short position in oil heating futures? The answer is long, in my book, but I don't understand why.

I am in long in jet fuel, so why am I also long heat oil?

Can someone explain, how this works? Thank you!

## Answer by Kyle Balkissoon (score 2, accepted)

https://quant.stackexchange.com/a/15877

This is a much simpler problem than stated, (assuming the correlation is positive).

In 1 month you need to BUY 2mn of jet fuel.

If Jet fuel prices go up, you lose money as it's more expensive. If jet fuel prices go down, you make money as it's cheaper.

So to "hedge" your risk you will LONG the heating oil, as you are not in the business of speculating on oil prices, to lock in your margins. So regardless of where prices of jet fuel go, the margins are preserved.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.