J&L RailroadQuestions

1.Should S&L hedge all ofits exposure to diesel fuel for the ensuring year? What percentage of the 210 million gallonswould you hedge?

2.What are the pros and consof using NYMEX contracts versus using the risk management products offered byKCNB? Is the use of a monthly averageprice a net advantage or disadvantage to J&L? What about for the bank?

Characterstics of NYMes standardized

Kcnb over the counter the argrumentsagainst

3.Using the estimate of 17.5million gallons per month, how would you construct a NYMEX futures hedge forthe next 12 months? How would youconstruct a commodity-swap hedge?

4.Should Matthews use a capas a hedge? What strike price for the cap would you recommend she choose?

5.If Matthews want to minimizethe cost of hedging, should she use a collar?What cap and floor strike prices would you recommend using?

Collar zero cost collar calculation

6.Did Matthews do a good jobof summarizing the pros and cons of using NYMEX contracts versus using the riskmanagement products offered by KCNB?

7.Using the Black-Scholesmodel as adapted for futures contracts, what inputs should you use to price thecaps and floors? Explain your choice foreach variable with particular attention to your estimate of volatility. How do your prices compare to KCNBsquotes? What would explain the pricingdifferences relative to NYMEX options?

HINT: To price an option on a futures contract, theBlack-Scholes model uses the futures price as the underlying asset, and thedividend yield is set to the risk-free rate.

8.How could KCNB make moneyon the J&L hedges? How would KCNBhedge its side of the contract (i.e., how would the bank offset the exposurecreated by selling its average price products using NYMEX futures and options)?

9.How should Matthews adjustthe accounting records for the commodity swap?

10.What could Matthews do toprotect herself from criticism of her proposal while retaining credit for beingthe champion of hedging?