Financial Engineering: Hedging Strategies and Derivatives Report

This report provides a comprehensive overview of financial engineering, focusing on the application of derivatives and hedging strategies within the airline and jet fuel industries. It begins with an introduction to the derivatives market, including instruments like futures, forwards, swaps, and options, and their role in mitigating market volatility. The report then delves into a literature review, detailing how airlines and jet fuel traders utilize these derivatives. Key strategies such as swap contracts, call options, collar hedges, and oil contract purchases are discussed. The core of the report involves case studies of Delta Corp and China Aviation Oil, analyzing their hedging strategies, successes, and failures, including the problems and actions that led to significant losses. The report also explores the debate of whether hedging is superior to no hedging in the current financial climate and examines control mechanisms companies can implement to protect against the misuse of derivatives. The conclusion summarizes the key findings and emphasizes the importance of derivatives and hedging in managing risk within the volatile commodity market.

Running head: FINANCIAL ENGINEERING
Financial Engineering
Name of the Student:
Name of the University:
Authors Note:

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Table of Contents
Introduction:...............................................................................................................................2
Literature review: (Stating the derivatives used by airline companies and jet fuel traders for
hedging the fuel price)...............................................................................................................2
Evaluating the strategies used by Delta and China Aviation oil corporation limited, while
identifying the problems and actions which turned against them:.............................................5
Identifying whether no hedge is better than hedge:...................................................................7
Depicting the control mechanisms that companies can use to protect them against wrong use
of derivatives transactions:.........................................................................................................8
Conclusion:................................................................................................................................9
Reference and Bibliography:....................................................................................................11

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Introduction:
The report focuses on delivering the current position of the derivatives market, which
is being traded all around the world. In addition, the report also depicts financial instruments,
which is been used in the current market for hedging and speculative trades. Furthermore, the
derivatives market consists of different types of contracts such as future contract, forward
contract, swaps, and options. The combination of the trades conducted by investors and
companies to hedge their current position in the market and reduce the negative impact of
volatile capital market. In addition, the contract of crude oil is evaluated in the section, which
could allow investors to adequately hedge their exposure of commodity market. Moreover,
the relevant needs for hedging instrument for fuel and airline industries are adequately
evaluated. Moreover, with the help of forward contracts fuel and airline industry can fix the
rising prices of crude oil and reduce their exposure from the volatile commodity market.
The role of hedging is immense in the fuel & airline industry, as it helps in curbing
the high risk involved in crude oil trade. The changing price of crude oil is the mainly factor
for fuel & airline industry, which helps them change their current project and view point
regarding their organisational strategy. Declining fuel price would help airline industry, while
hampers the actual profitability of fuel industry (Hull and Basu 2016.). Hence, derivatives
market and hedging process is essential for fuel & airline industry, as it helps them to reduce
the negative impact from volatility commodity market.
Literature review: (Stating the derivatives used by airline companies and jet fuel
traders for hedging the fuel price)
There are four different types of derivative instruments, which is currently being used
by Jet fuel trader’s and airline companies. The hedging instruments such as future contract,

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forward contract, swaps, and options are ad3ually being used by companies all around the
world. However, the following instruments are used by the current companies falling under
Jet fuel and Airline.
Purchase of Swap Contracts:
The Jet fuel and Airline companies are current focused in using swap contracts for
hedging their current position in the market and reducing the negative impact from volatile
commodity market. The purchase of swap contacts is conducted for reducing the fuel cost,
while the contract has stringent guidelines incorporated within its workings. Furthermore, the
swap strategy is as the call option where the individual does not conduct relevant delivery of
the stock or commodity. In addition, the swap contracts do not oblige the oil companies to
purchase the end commodity at the completion or expirer of the contract. Instead they provide
company with adequate leverage and position for the period, which could help them hedge
their currency exposure in the commodity market (Chance and Brooks 2015).
Call option purchasing:
Purchasing of call option can also be conducted by Jet fuel and Airline companies for
addressing the risk, which is persistent in the commodity market. In addition, the buying of
call option mainly allows the Jet fuel traders and Airline companies to fix a certain price at
which the stock can be sold in future date. This measure mainly helps in reducing the
negative impact of volatile capital market, while conducting effective trades to reduce their
expenses on crude oil purchase. However, the call option is beneficial for the Jet fuel traders
and Airline companies for reducing the excessive increment in losses due to the rising
volatility in crude oil market. Strong and Jeyasreedharan (2017) mentioned that with the use
of call option companies can hedge their current exposure and minimise the risk that might be
portrayed from external factors.

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Conducting collar hedge:
The different type of trading such as collar hedge can be conducted by the company,
which might help in reducing the excess risk from investment. In addition, the collar hedge
uses one put and one call option for hedging the exposure of Jet fuel traders and Airline
companies. Moreover, this helps in controlling the abrupt risk, which might incur from
operations. Therefore, one call option and one put option needs to be purchased by the
investor, which might help in reducing the risk from investment. The trade is mainly
conducted by Jet fuel traders and Airline companies when they are not certain regarding the
trend of the crude oil market. This type of trade mitigates the risk of investment from trades
conducted by Jet fuel traders and Airline companies. Furthermore, the use of collar hedge
minimises the risk from investment, while declining the losses obtained by the company
(Duffie and Stein 2015).
Oil contract purchase:
The purchase of oil contracts is mainly conducted by companies, when they estimate
that prices of oil will increase industry. The Jet fuel traders and Airline companies mainly
buy excessive contract of credo oil, which enables them to minimise the risk from investment
and hedge against high prices of crude oil. However, the main problem in the hedging
measures is when prices of crude oil starts to decline, which raises the level of losses and risk
for the Jet fuel traders and Airline companies. Moreover, Jet fuel traders and Airline
companies only use the trade in the anticipation of prices going up, which might reduce the
risk from investment and decline their risk exposure in commodity market (Rajan and
Zingales 2015).

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Evaluating the strategies used by Delta and China Aviation oil corporation limited,
while identifying the problems and actions which turned against them:
Evaluation of the strategies that was being used by Delta Corp:
After evaluating the case study relevant factors and actions that was taken by delta
Corp in their derivatives trades can be identified. In addition, the section directly delivers the
different type of actions and decisions that was taken by Delta Corp before the derivatives
market, which increased their losses are pointed effective in the case study. There were two
instances to the Delta Corp case, where in one part the company was not able to use adequate
hedging strategies for curbing the rising expenses on oil, while on the other part the effective
hedge trades were being conducted to minimising the losses from rising crude oil. Moreover,
for the first part of the case study the company was struggle for its hedge funds and appointed
Jon Ruggles as their hedge fund manager. Jon Ruggles with the expertise in commodity
market was able to turn around the overall hedging situation of Delta Corp, which allowed
them to make adequate profits. In addition, the rising expenses incurred from oil prices was
effectively hedged, which reduced the exposure losses for the organization (Valdez and
Molyneux 2015).
The main problem when Jon Ruggles took an adverse bet the crude oil process would
be in turn range of $105 to $125, which was the case. This estimation of the crude oil prices
was wrong, where the actual oil price increased over the period and rise concern for Jon
Ruggles. The losses on commodity market escalated when the price of oil reached $100,
where the losses of the company piled up. However, the management was reluctant to hand
over the hedging process to Jon Ruggles and regardless of his advice the company took extra
swaps in $100, where the oil price declined further to $88. This tripled the losses for the
organization and hampered their capability to continue with their hedging exposure in

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commodity market. The case study indicates the bad decision that was made by management
and Jon Ruggles while conducting relevant trades during the period.
Evaluation of the strategies that was being used by China Aviation Oil (Singapore)
Corporation Ltd:
The case study evaluation of China Aviation Oil Corporation Limited mainly
indicates the problems that was faced by the company during the period. In addition, China
Aviation Oil Corporation Limited was conducting adequate trades and was committed to
brokerage income. However, the main proems started when the company used speculative
measure to increase their profits in commodity market. This step in the speculative trading
structure mainly raise the level of risk and reward capability of China Aviation Oil
Corporation Limited. Moreover, during the end of 2003 the CEO of China Aviation Oil
Corporation Limited took a bet that price of crude oil will not increase $38 per barrel in the
community market. The significant exposure to the commodity market relevantly increased
exposure of the company. In addition, the January of 2004 the overall price of crude oil
increased from $38, which significantly increased losses of the company by $390 and $160 in
unreleased losses. This summed up the loses of China Aviation Oil Corporation Limited to
$550million at the end of January 2004.
However, the condition of China Aviation Oil Corporation Limited was evaluated by
Price Water House Coopers, who detected the problems in valuation of derivatives. The
valuation of derivatives conducted on normal values, while the intrinsic value was not used,
which helps in depicting the overall time value of money (Oldani 2016). Hence, ignorance of
the value mainly hampered the profitability of company in continuing with the commodity
trade. The problem mainly escalated when the CEO of China Aviation Oil Corporation
Limited used additional trades for compensating the current loses incurred from the risk

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exposure. The new trades would increase potential losses for the origination, which ended
their yearlong monopoly in the Asian market.
Identifying whether no hedge is better than hedge:
The statement No hedge is better than hedge is relatively not adequate for the current
financial market, where risk attributes and volatility are higher in comparison to previous
markets. Furthermore, the derivative instrument is considered as one of the Lethal weapons
that could be used in the financial market and hamper its progress. According to Warren
Buffett, derivatives is a kind of time bomb, which needs to be evaluated adequately before it
affects the market or the investor. Furthermore, Bomfim (2015) added that without the
innovation of derivatives instrument organizations and hedge fund managers cannot reduce
the risk, which was generated from capital market. Currently the derivatives market is used to
identify the demand and supply of particular products and shares, which enables
organizations to reduce the risk from volatile commodity market. However, the rising use of
derivative instruments has increase the fluctuation on market pricing, which in turn hampers
the actual financial returns of an organization. Therefore, omitting the use of hedge could be
drastic for organizations, which are dependent on certain commodities for their production.
With the help of hedging process companies are mainly able to reduce their exposure
from the volatile capital market, which is affecting their revenue stream. Moreover,
derivatives instruments are an effective way by which companies can hedge their actual
exposure in the market, seeing any short-term volatility that might hamper their progress. In
addition, without the hedging instrument multinational companies would not be able to
survive the harsh environment of the currency commodity market. Banks (2016) mentioned
that with the help of hedging process organizations can reduce the risk from currency
conversion and fix the overall cash inflows and outflows that is conducted International.

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The evaluation of the current financial crisis of 2008 mainly depicts the use of
derivatives, which nearly brought down the financial sector of the world. However, with
problems that was faced during the financial crisis derivatives also allowed investors to hedge
the risk against volatility. This relatively helped in reducing the losses which might occur due
to the volatile capital market. Therefore, it could be said that hedging is the appropriate
approach which could be used by investors to reduce the risk of losses from investment.
Depicting the control mechanisms that companies can use to protect them against
wrong use of derivatives transactions:
Conducting no speculative trades:
The major problems identified from the evaluation of both the case studies indicated
the use of speculative treats conducted by companies. Therefore, relevant measures need to
be conducted by companies and investors to reduce the usage of speculative trades with the
help of derivative markets. due to the high leverage provided by derivative instrument,
investors can conduct high-end trades by providing premiums on the trade. This speculative
trade need to stop by the organization, as it increases the risk exposure of the company, which
is not needed for conducting their operations. Companies needs to conduct trades, which they
found the underlying value, as it helps in reducing the problems that might incur in future.
Furthermore, the commodity that is used by the company needs to be hedged, while other
instruments and products can be ignored by the organization (Moreni and Pallavicini 2017).
Use of appropriate hedging measures:
The use of appropriate hedging measures needs to be conducted by the company
before initiating the trade. this hedging measure can be futures contract, forward contract,
options or swaps, whichever is necessary by the organization to reduce their risk from

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investment. The selection of inadequate hedging measure is one of the reasons, which
increases the risk of the organization and forces them to incur loss. Therefore, the company
needs to evaluate the actual trades that it good conduct to fulfill the hedging requirements and
reduce the risk from investment. In this context, Abad et al. (2016) mentioned that with the
use of appropriate hedging contract companies are able to minimize their risk exposure in the
market.
Monitoring controlling the trades:
Moreover, relevant monitoring and controlling process needs to be conducted by
companies after the successful completion of the trade. This monitoring process could
eventually help in reducing the losses, which might incur due to sudden price movements.
hence, companies with the help of monitoring process could to detect the viability of that
reads and conduct relevant decisions based on the changing volatility in the market. This
could eventually help in reducing the losses that might incur from investment. Furthermore,
relevant use of control in the trades needs to be conducted by the companies, where adequate
authorities responsible for the trade. The companies can use individual or group, which could
evaluate the trades and their value before starting the actual trades. This monitoring and
controlling measures would eventually help in reducing the excessive losses that might incur
by the company, due to wrong hedging process (Gospodinov and Wei 2015).
Conclusion:
The report provides justification for the use of adequate hedging measures by
companies to reduce the risk from investment. In addition, the evaluation of both case studies
indicates the problematic trades that were conducted by companies to hedge their exposure in
the market. Both the companies used swaps for their hedging their process and to cover up
the losses that might incur from trading. furthermore, the need of hedging and hatching

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process is also depicted, which would allow investors to reduce the risk from investment. In
addition, the volatile capital market needs adequate hedging instruments that could be used
by investors for hedging their current exposure. Lastly, adequate measures that could be used
by companies for reducing the negative impact of hedging contracts are depicted in the
assessment. This could eventually help in reducing the risk that might incur by the company
due to high end risk. Therefore, it could be stated that with the use of hedging process
multinational companies, hedge fund managers, commodity managers, and other financial
controller can reduce the risk from volatile capital and commodity market. The derivative
instrument allows the traders to minimize the risk by providing a premium on the actual bet,
which does not comprise of the actual underlying value of the trade.

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Reference and Bibliography:
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S., Neychev, M. and Roukny, T., 2016. Shedding light on dark markets: First insights from
the new EU-wide OTC derivatives dataset. ESRB Occasional Paper Series, 10, pp.1-32.
Banks, E., 2016. The credit risk of complex derivatives. Springer.
Bomfim, A.N., 2015. Understanding credit derivatives and related instruments. Academic
Press.
Brito, J., Shadab, H. and Castillo, A., 2014. Bitcoin financial regulation: Securities,
derivatives, prediction markets, and gambling. Colum. Sci. & Tech. L. Rev., 16, p.144.
Chance, D.M. and Brooks, R., 2015. Introduction to derivatives and risk management.
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Christoffersen, P., Goyenko, R., Jacobs, K. and Karoui, M., 2017. Illiquidity premia in the
equity options market. The Review of Financial Studies, 31(3), pp.811-851.
Duffie, D. and Stein, J.C., 2015. Reforming LIBOR and other financial market
benchmarks. Journal of Economic Perspectives, 29(2), pp.191-212.
Ericsson, J., Reneby, J. and Wang, H., 2015. Can structural models price default risk?
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Derivatives Markets. RBA Bulletin, December, pp.63-74.

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Gospodinov, N. and Wei, B., 2015. A Note on Extracting Inflation Expectations from Market
Prices of TIPS and Inflation Derivatives. Federal Reserve Bank of Atlanta.
Gupta, S.L., 2017. Financial Derivatives: Theory, concepts and problems. PHI Learning Pvt.
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Strong, R.A. and Jeyasreedharan, N., 2017. Understanding Derivatives: Options, Futures,
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