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FRM Part I · FRM Exam Part I · How Do Firms Manage Financial Risk?

A US airline expects to buy 2,000,000 gallons of jet fuel in three months. Its CFO wants to remove the cash-flow volatility from fuel price changes, and is willing to give up any benefit if prices fall. Which hedging instrument best matches this objective?

Buying jet fuel forward contracts best fits. The airline is naturally short fuel and is hurt by price rises, so a long forward fixes the purchase price and removes variability, at the cost of forgoing gains if prices fall. A call would preserve those gains but requires a premium.

  1. ABuying a call option on jet fuel
  2. BSelling jet fuel forward contracts
  3. CBuying jet fuel forward contractsCorrect
  4. DSelling a put option on jet fuel

Explanation

The airline is exposed to rising fuel prices, so it needs a long position. A long forward locks in the purchase price and eliminates variability, while giving up gains if prices fall. A call would keep the downside benefit but costs a premium, which does not match the stated willingness to forgo gains. Selling forwards would increase the exposure.

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