Question IV

Some U.S. corporations have substantial dependence on foreign oil imports for their energy consumptions. The oil prices, though priced in dollars, are very volatile and create significant fluctuations in net income.

a) Elaborate how the firm can use the futures market to reduce its risk exposure. Should the firm buy or sell futures contract? Please outline the steps in executing this risk management process. (6 marks)

b) Discuss how the change in basis may impact the hedging. (4 marks)

c) Explain how the firm can use options to hedge this risk exposure? (4 marks)

d) Compare and contrast the risk management in (b) and (c) (3 marks)

e) Explain how futures market can be also used by speculators. What position will you recommend if oil price is expected to decline? (3 marks)

(20 marks)