Welcome to the hedge simulator

Because of one lucky shot in your last golf game with the CEO, you have just been appointed chief financial officer for a major airline and discovered that one of your largest expenditures, one that is changing constantly and could potentially bankrupt your firm, is the cost of jet fuel. Your airline has a constant demand for fuel of 100000 barrels/week and the price of a barrel changes weekly, going up by $1.00 with probability ½ or going down with probability 1/2 . (It never stays the same two weeks in a row). The current price is $60/barrel, so it looks like the price should average around $60. If the average over the next year is greater than $63, the CEO has kindly informed you (on the 17’th hole) that the airline will lose money and, worse luck, you will lose your job unless you can find a way to shelter the company against this increase in price.

What is the probability that you are fired?

What if you buy an option or “price guarantee” which guarantees to make up the difference, if any, between the average price per barrel for the year and the guarantee price. For example if you pay me an insurance premium of about $0.87 per barrel for a guaranteed price of $62, then if the average price over the year exceeds $62, I will pay you the difference.

price premium

61.0000 1.2400

62.0000 0.8700

63.0000 0.5900

64.0000 0.3900

65.0000 0.2400

66.0000 0.1400

67.0000 0.0800

68.0000 0.0400

69.0000 0.0200

70.0000 0.0100