Air Jethro was organized on January 1, 2017, and expected to be able to begin providing air service in eighteen months, with the first flight scheduled for July 1, 2018.

At the time Air Jethro was organized, there was great uncertainty about the future price of oil (i.e. fuel). Since fuel will be a significant portion of Air Jethro's operating expenditures, Air Jethro had to decide an appropriate fuel strategy. Air Jethro expects to use the equivalent of 250,000 barrels of oil during the period July 1, 2018 to December 31, 2018. One possibility under consideration was purchasing 250,000 barrels of oil on January 1, 2017, and then hedging its "fair value" so that if the scheduled flights never took place, Air Jethro would not lose money on the oil that had been purchased.

On January 1, 2017, 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, 2017 is $ 55.00 per barrel and that the spot price of oil on June 30, 2018 is $ 65.00 per barrel. (Note that these amounts are not known on January 1, 2017, and only become known as time passes.)

Problem 2 (1.5 Points)

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?

Given your answer to the previous question, with respect to the transactions described above, please indicate the numbers that would appear on Air Jethro's financial statements for the following items (if the item will not appear on a financial statement, please indicate this by putting $ 0 in the applicable line(s)).

Oil Inventory - December 31, 2017: $ ____

Derivative Asset / Liability (underline one)

on December 31, 2017: $ __

Net Income: Year-Ending Dec. 31, 2017: $ ______

Comprehensive Income: Year-Ending Dec. 31, 2017: $ ______

Problem 3 (1.5 Points)

Assume that on January 1, 2017, rather than purchasing immediately, Air Jethro decides to defer the purchase of 250,000 barrels of oil from Clampett Oil until June 30, 2018, paying the prevailing spot rate on that date. Also, assume that on January 1, 2017, Air Jethro enters into three oil derivative contracts with Drysdale Financial, and designates the contracts as a "cash flow hedge".

First Question: In order to create a cash flow hedge, should Air Jethro

take the position of Party A or Party B in the contract with

Drysdale Financial?

Given your answer to the previous question, with respect to the transactions described above, please indicate the applicable numbers that would appear on Air Jethro's financial statements:

Oil Inventory - December 31, 2017: $ _______

Derivative Asset / Liability (underline one)

on December 31, 2017: $ _______

Net Income: Year-Ending Dec. 31, 2017: $ ______

Comprehensive Income: Year-Ending Dec. 31, 2017: $ _______