On Dec 31st 2007 the COO of Southwest comes out with an estimate of expected fuel consumption for the next five months of 600 million gallons. The CFO is considering to buy a financial "insurance" on oil price using options with maturity May 2008. Table 1 reports the prices on Dec 31st, 2007, of a set of call and put options on crude oil. All options have maturity date of May 15, 2008 (time to maturity T=0.3715) and can only be exercised at maturity. The options' underlying is one lot of 1,000 crude oil barrels, which equals 42,000 gallons of crude oil. Do the following: 1. (5% of grade) Under no hedging, is Southwest naturally long or naturally short jet fuel? Think about the economics of "jet fuel risk" and draw a payoff diagram with Southwest exposure to jet fuel. Please label the axes of the diagram, specify the units of measure and show some values on each axis. 2. (15% of grade) Assume that the CFO is worried of a further change in oil price. The CFO wants to use options and decides to use the $105 strike options on oil (we can refer to this strategy as straight insurance). Exposure variables Table 1 Fuel Usage and Hedging Data for Southwest Airlines Hedging variables Available Fiscal year ends Year Fuel Hedge Used Fuel? Cost of Seat Fuel Miles (Million Fuel Cost Gallons) ($million) ($ per gallon) (ASM) (millions) Cost/ ASM Hedged Year Hedges Total Expenses ($ Millions) Expenses Millions) Revenue) (millions) Hedged (yrs) Total % of Fuel as a Revenue % of ($ Fuel Cost (% of Gallons Next Longest Maturity of 31-Dec 2000 Yes 1022.2 31-Dec 1999 Yes 939.1 $ 804.4 $ 495.0 $ $ 0.7869 59,910 $ 0.0081 $ 4,628 10.5% $ 5,649 8.6% N/A 80.00% 3.00 $ 0.5271 52,855 $ 0.0094 $ 3,954 12.5% $ 4,736 10.5% 126.10 86.00% >1 31-Dec 1998 Yes 850.3 388.3 $ 0.4567 47,544 $ 0.0082 $ 3,480 11.2% $ 4,164 9.3% 31-Dec 1997 Yes 792.4 $ 495.0 290.00 not 33.00% 0.50 not $ 0.6246 44,487 $ 0.0111 $ 3,293 15.0% $ 3,817 13.0% 31-Dec 1996 Yes 740.3 $ 484.7 $ 0.6547 40,727 $ 0.0119 $3,055 15.9% $ 3,406 14.2% material material not not material material N/A N/A $ 31-Dec 1995 Yes 662.2 365.7 $ 0.5522 38,180 $ 0.0101 $2,559 14.3% $ 2,873 12.7% 1.05 2.00%