J&L Hedge

INTRODUCTION

Although having an upward trend of total operative revenue from 2006-2008; J&L Railroad’s operating income had decreased significantly in 2008, and it was expected to continue decreasing in the following years. The main reasons were because the fuel cost had increased rapidly, and the railway industry did not allow the company to increase its prices. Thus, the CFO of J&L Railroad had decided to consider about hedging the cost of fuel. The question had arisen whether the fuel cost should be hedged; also, to what extent J&L should use hedging.

METHODOLOGY

Wishing to get a wide range of alternative solutions, each of us has individually analyzed the problems provided in the assignment and found the proper solutions before brainstorming as a group. When started brainstorming, we reconsidered whether J&L Railroad should hedge the fuel cost. Then we reconsidered how much the company should hedge the fuel cost, and the structure of hedging. After analyzing every question in the assignment including the pros and cons of using various hedging strategies, we have founded that using the KCNB collar is likely to be the best choice. To decide between the collar’s strike prices and the extent to which the cost should be hedged, we calculated the difference between the required amount of money for purchasing 17.5 million gallons at various actual average price for a year and that for purchasing the same quantity at $1.36 per gallon (the current spot price). Then we have numerically compared the loss and benefit of various hedging strategies; moreover, the premium costs were also taken into account. See appendix.

ANALYSIS AND RECOMMENDATIONS

1. Should J&L hedge its fuel costs?

After considering the arguments for and against the hedging decision, we have concluded that J&L should hedge its fuel costs using derivatives.

* What are the most important arguments for and against a corporation’s hedging this type of...