Case 1: Hedging Case

Canuck Oil Corporation is a Canadian crude oil producer. Today is July 15. Canuck's estimated oil production level in three months' time will be 100,000 barrels. The current spot price for crude oil is US$90.29 per barrel. Between January 15 and now, crude oil prices have fluctuated from a high of $110.82 to a low of $90.56.

Due to the unstable nature of crude oil prices, Canuck Oil's financial manager, Mr. Petro Stark would like to hedge the crude price risk using crude oil futures contracts. Petro found the following information on futures contracts expiring in September, October, and November:

Delivery month

Last

Change

Prior settlement

Open

High

Low

Volume

September

90.79

-0.58

91.37

91.24

91.44

89.76

9067

October

92.18

-0.48

92.66

92.89

95.22

89.30

5229

November

90.13

-0.35

90.48

90.22

90.55

89.08

1685

Contract size: 1,000 barrels

Contract currency: US dollar

September expiry: September 16

October expiry: October 16

November expiry: November 16

Assume that the company hedges using the futures contracts, and the settlement prices on the futures contract used change as in the table below. The company's broker demands an initial margin of $600,000 and a maintenance margin of $500,000. Set up a margin account table using these settlement prices, assuming that any excess over the initial margin will be withdrawn and deposited into the company's bank account.

Date

Settlement Price

Price Change

July 16

$92.64

July 21

$95.82

$3.18

July 26

$96.44

$0.62

July 31

$94.35

-$2.09

Aug. 5

$97.34

$2.99

Aug. 11

$96.93

-$0.41

Aug. 16

$98.23

$1.30

Aug. 21

$98.26

$0.03

Aug. 26

$97.61

-$0.65

Aug. 31

$97.57

-$0.04

Sept. 5

$98.09

$0.52

Sept. 11

$98.23

$0.14

Sept. 16

$102.59

$4.36

Sept. 21

$103.81

$1.22

Sept. 26

$104.19

$0.38

Sept. 30

$104.76

$0.57

Oct. 5

$105.18

$0.42

Oct. 11

$106.06

$0.88

Oct. 15

$106.07

$0.01

Oct. 21

$103.83

-$2.24

Oct. 26

$101.88

-$1.95

Oct. 31

$100.56

-$1.32

Nov. 5

$101.73

$1.17

Nov. 11

$101.48

-$0.25

Nov. 16

$103.61

$2.13

Nov. 21

$102.93

-$0.68

Nov. 26

$104.06

$1.13

Aside from futures contracts, what other derivative instruments can the company use to hedge its exposure to crude oil prices?

Canuck Oil is also exposed to interest rate risk, as it has issued 2,000 fixed rate coupon bonds with a face value of $1,000 each. The current interest rate on similar coupon bonds is 8%. The company can also borrow at a rate of prime + 2%. Mr. Rich believes that the interest rate will fall in the future, and would like to see if the company can switch to a flexible interest rate on its debt. Describe how the company and its investment dealer can design a plain vanilla swap with a counterparty who can borrow at a fixed rate of 10% or a flexible rate of prime + 1%. The investment dealer generally makes a spread of 1% on this type of swap. Use a diagram to illustrate this swap transaction.