GF561 Unit 10 Paving Derivatives Strategy Report Example

Futures, Collars and a Swap Under One Set of Limits: A Unit 10 Derivatives Strategy Report for a Paving Contractor

[Student Name]

Purdue University Global

GF561: Derivatives and Hedging

Unit 10 Derivatives Strategy Report

[Instructor Name]

[Date]

The paving contractor, its program and every figure are composite and illustrative, carried from earlier units; the articles and textbook cited are real.

Summary for the Finance Committee

The program protects the contractor's margins on fixed-price paving bids and fixes the interest cost of its equipment loan. In a severe but plausible stress, falling crude prices and falling interest rates together, it would require about $4.2 million of cash for margin and collateral within a few weeks. That cash would be recovered over time through cheaper asphalt and lower loan interest, but it must be available on demand. The committee is asked to approve the positions, raise the margin and collateral facility to $5 million and adopt five limits.

The Positions

This season's asphalt, May through October. 109 crude oil futures contracts, long, layered across six contract months, hedging 60 percent of an expected 54,000 tons of asphalt binder at a minimum-variance ratio of 3.36 barrels per ton. Expected variance reduction on the hedged tons: about 61 percent.

Next season's asphalt. 54 collars on crude oil futures with nine months to expiry, each buying a call struck at $80 and selling a put struck at $64 against a futures price of $72. With 30 percent implied volatility, the call costs about $4.36 a barrel and the put brings in about $3.62, a net cost of about $0.73 a barrel, or roughly $39,500 for 54,000 barrels. The collars cover about 30 percent of next season's expected purchases, leaving room to add futures once the bid calendar is clearer.

The equipment loan. A pay-fixed swap on $40 million at 4.10 percent, with two years and three months left, currently valued at about negative $287,000 to the contractor. Each one basis point fall in rates lowers its value by about $7,800.

Why Collars for Next Season

Next season's bids have not yet been won, so the volume to hedge is uncertain. Futures would lock a price on barrels the contractor may not need. Collars cap the cost of asphalt at about $80 crude while costing little, and if prices fall the contractor gives up savings only below $64. Research on corporate hedging finds that firms facing uncertain quantities tend to prefer options to linear hedges for exactly this reason (Brown & Toft, 2002).

Stress Test

The stress combines a $25-a-barrel fall in crude within a month with a 100-basis-point fall in interest rates.

1. Futures. 109 contracts times $25 times 1,000 barrels: about $2.73 million in margin calls.

2. Collars. With crude at $47, the sold puts are $17 in the money: 54 contracts times $17 times 1,000 barrels, about $918,000 in margin or value loss.

3. Swap. Its value falls to about negative $1.08 million. Under the collateral agreement, the contractor posts collateral above a $500,000 threshold: about $576,000.

Total stressed cash need: about $4.22 million.

Every dollar of the stressed cash need is matched by a later saving, on asphalt bought more cheaply and on interest paid at lower floating rates, but the margin and collateral are due within days while the savings arrive over months, so the program's real risk is liquidity rather than loss.

Funding the Program

The contractor's existing margin line of $2 million covers a moderate stress but not this one. Raising the facility to $5 million, about 1.2 times the stressed need, would let the program survive a severe month without forced liquidation. Research on hedging failures finds that programs often fail not because the hedge is wrong but because the firm cannot fund interim losses and is forced to close positions at the worst time (Culp & Miller, 1995).

Limits

1. Hedge ratio. No more than 75 percent of expected purchases hedged in any month, and no more than the expected tons times the approved ratio of 3.36 barrels per ton.

2. Tenor. No hedge more than eighteen months beyond the current date.

3. Option selling. Options may be sold only as part of a collar against bought options on the same volume.

4. Liquidity. The committed facility must exceed 1.2 times the stressed cash need, recalculated each quarter.

5. Counterparties. Over-the-counter positions only with banks rated in the A category or higher, with collateral agreements in place.

Reporting

The treasurer will report monthly to the finance committee on position sizes against limits, the asphalt-to-crude correlation, the swap's value and the stressed cash need. Any limit breach will be reported within two business days with a plan to cure it.

Accounting

All three programs are designated as cash flow hedges, which parks their gains and losses outside earnings until the related asphalt purchases or interest payments arrive (Hull, 2022). Documentation of each hedge relationship must be completed before the position is opened.

Risks the Program Does Not Cover

Asphalt price moves unrelated to crude, discussed in the residual review, remain. A sharp rise in interest rates would make the swap valuable but would also raise the contractor's other borrowing costs not covered by the swap. And the program cannot protect the contractor from losing bids to competitors whose asphalt costs are lower.

How the Program Was Built

The program grew from the earlier units of analysis. The futures position follows the minimum-variance sizing in the hedge design memo, the collars reflect the option strategy comparison's preference for floors without large premiums, and the swap's value and rate sensitivity come from the swap valuation. The residual review shaped two of the limits: the cap on barrels per ton prevents the over-hedging that a volume shortfall would otherwise create, and the liquidity limit answers the margin residual directly.

What Would Change the Program

Three developments would prompt a revision. A sustained fall in the asphalt-to-crude correlation below 0.70 would weaken the futures hedge enough to reconsider an asphalt index swap. A large new state contract with an asphalt adjustment clause would lower the share of work needing a hedge. And a refinancing of the equipment loan would require the swap to be resized or closed.

Expected Cost of the Program

The futures carry no premium, only commissions and the cost of the margin facility, about $60,000 a year in commitment fees at the proposed size. The collars cost about $39,500. The swap has no upfront cost. Against a season's asphalt purchases of roughly $33 million, the program's direct cost is well under 1 percent.

Decisions Requested

Approve the three positions, increase the margin and collateral facility to $5 million, adopt the five limits and the monthly report.

References

Brown, G. W., & Toft, K. B. (2002). How firms should hedge. The Review of Financial Studies, 15(4), 1283-1324. https://doi.org/10.1093/rfs/15.4.1283

Culp, C. L., & Miller, M. H. (1995). Metallgesellschaft and the economics of synthetic storage. Journal of Applied Corporate Finance, 7(4), 62-76. https://doi.org/10.1111/j.1745-6622.1995.tb00263.x

Hull, J. C. (2022). Options, futures, and other derivatives (11th ed.). Pearson.