Use of Derivatives Fixed Price Instruments for Fuel

Price Exposure

Prof Dr Malick Sy
msingdia85@gmail.com
 Agenda

• General Understanding of Swap Transactions : From Interest

Swap to Commodity Swap

• Swaps in Jet Fuel

• Swaps in Crude Oil

• Swaps in the Jet to Crude Crack

• Oil futures

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 General Understanding of Swap
Transactions: From IRS to Commodity
Swap

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 Market Organization
• Most swaps are tailor-made contracts.
- Swaps trade in an OTC type environment.
- Swap specialists fill the role of broker and/or market maker.
- Brokers/market makers are usually large banks.
- Prices are quoted with respect to a standard, or generic, swap.

• All-in-cost: price of the swap (quoted as the rate the fixed-rate

side will pay to the floating-rate side)
• It is quoted on a semiannual basis:
absolute level ("9% fixed against six-month LIBOR flat")
bp spread over the U.S. Treasury yield curve ("the Treasury
yield plus 57 bps against six-month LIBOR flat").

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 "LIBOR flat" = LIBOR is quoted without a
premium or discount.
The fixed-rate payer is said to be "long“, having "bought" the swap.
Example: Houseman Bank's indicative swap pricing schedule.
Maturity HB Receives Fixed HB Pays Fixed
1 year 1-yr TN sa + 44 bps 2-yr TN sa + 39 bps
2 years 2-yr TN sa + 50 bps 2-yr TN sa + 45 bps
3 years 3-yr TN sa + 54 bps 3-yr TN sa + 48 bps
4 years 4-yr TN sa + 55 bps 4-yr TN sa + 49 bps
5 years 5-yr TN sa + 60 bps 5-yr TN sa + 53 bps
Consider the 3-year swap quote: Housemann Bank attempts to sell a
3- year swap to receive the offered spread of 54 bps, and buy it back
to pay the bid spread of 48 bps. HB’s profit: 6 bps.

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 Example: Goyco wants to receive fixed-rate
payments rather than pay fixed-rate for 3 yrs
The current (“on the run”) 3-yr Treasury Note rate is 6.53%.
Goyco decides to buy a 3-yr swap from Housemann Bank.

Calculation of fixed rate: HB will pay 7.01% (6.53+.48) s.a.

Note: LIBOR will be reset at (T-2) for the next 6-mo period.
Q: Are swaps riskless?
A: No! Default risk is always present.

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 The Dealer’s Perspective
A swap dealer intermediating (making a market in) swaps makes a
living out of the spread between the two sides of the swap.
Example: Houseman Bank enters into a 3-year swap with Goyco.
3-year quote: 3-yr TN sa + 48 bps & 3-yr TN sa + 54 bps
The on the run 3-yr Treasury Note rate is 6.53%.

HB finds a counterparty A => HB gets rid of the swap exposure.

Note: The difference between the rate paid by the fixed-rate payer
over the rate of the on the run Treasuries with the same maturity as
the swap is called the swap spread. The swap spread here is 54 bps.

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 Commodity Swaps

Commodity swaps work like any other swap: one legs involves a
fixed commodity price and the other leg a (variable) commodity
market price.
Unlike futures commodity contracts, cash settlement is the norm.
Example: Jet fuel oil swap.
Airline A enters into a 2-year jet-fuel oil swap. Every quarter, Airline A
receives the average market price –based on a known price quote-
and pays a fixed price.

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 Commodity for Interest Swaps

Example: An oil producer enters into a 2-year swap. Every six month,
the oil producer pays the return on oil –based on NYMEX Light Crude
Oil- and receives 6-mo LIBOR.

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Hedging Description Benefits Potential Costs
Tools

Enables the airline to eliminate their price No upfront premium

exposure, protecting themselves from a rise
Fixed for in fuel prices. By receiving the Forgone benefit
Floating floating market price from falling prices
Swap To do this the airline would enter a swap the client now has
and receive the floating market rate in greater control over
return for paying a fixed price. their cost base

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 Combination of Swaps
Example: A Brazilian oil producer is exposed to two forms of price risk
- the price of oil (P), priced in USD => commodity price risk.
- the price of dollars (St) => FX risk.

Expenses are in BRL. The Brazilian oil producer would like to fix the
price of oil in BRL/barrel of oil. A combination of swaps can do it!

Note: This is a typical problem for international commodity

producers and buyers: Commodities are priced in USD.

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Swaps in Jet Fuel

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 Description

Date of Contract Airline and Bank enter into a

Signing swap contract. Agree on (1)
Swap price, (2) maturity date,
(3) benchmark used and (4)
quantity hedged

Maturity date
Airline pays the bank if the swap price > market price
Settlement date
Bank pays the airline if the swap price < market price

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 Counterparty Risk

• Counterparty risk materialises for the airline when:

o The spot price of jet fuel rises above the swap

price;

o Which means the bank must pay the airline the

difference between the spot and swap price; and

o The bank goes bankrupt

• Airlines will reduce this risk by (1) choosing a variety of banks to sign
swap contracts with and (2) ensure that those banks have investment
grade credit rating

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Oil Futures

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 Essential Features of an Oil Futures Contract?

1. A contract between an 2. The airline and the

airline and another party other party agree on a
to buy or sell a specific price at the time the
quantity of oil transaction takes place

4. Contracts are negotiated 3. Delivery and payment

on a futures exchanges occurs at a specified future
date

5. Examples include NYMEX (NY

Mercantile Exchange)
ICE (Intercontinental Exchange)

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 Which products are primarily used for fuel
hedging?

NYMEX ICE

WTI Crude Oil Heating Gasoline Brent Crude Oil Gasoil

Oil (RBOB)

Heating Oil = liquid petroleum product used as a fuel oil for furnaces or boilers in buildings
Gasoil = a form of heating oil used primarily in heating and air-conditioning

RBOB = Reformulated Gasoline Blendstock for Oxygen Blending

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 Futures versus Swaps

Similarities
• They both attempt to lock in a price for fuel
• When modelling the cash flow impacts this is essentially the same

Differences

• Futures transactions take place via an exchange

• Swap transactions take place over-the-counter
• More risk of counterparty failure in the case of a swap
• Less risk of counterparty failure in the case of a futures transaction because
both parties to the transaction must open an account with the trading house
and make sure there is enough money there-in to settle the transaction on a
daily basis
• Swaps can be developed for any commodity
• Futures can only be developed for commodities offered by the exchange

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Use of Option Instruments for Fuel Price Exposure

Prof Dr Malick Sy
msingdia85@gmail.com
 Agenda

• Call options in jet fuel

• Call options in crude

• Put options in jet fuel

• Put options in crude

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Call Options in Jet Fuel

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 What is a jet call option?

· A jet call option is a contract

· It provides the airline the right but not the obligation to buy a
certain quantity of jet fuel on or before a specific date, the
expiration date, at a predetermined price, called the strike price

· The airline pays a premium, called the option premium, to buy the
option.

· The option premium is defined in terms of the number of barrels of

jet fuel consumed in the option contract

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 American, European and Asian Options

Option is exercised at Option is exercised on

any time prior to the Option is exercised on
the expiration date the average price over
expiration date
the option contract

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