J&L Railroad

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1. J & L should hedge only some of its exposures to diesel fuel. Although there are several financial instruments available for J & L to hedge against the risk of rising diesel fuel prices, these instruments still have their own downsides and possibly their own risks. For example, the future contracts from NYMEX seems like an effective hedging strategy for J &L, but there are some difficulties in terms of using futures from NYMEX to hedge against the diesel prices. NYMEX does not trade contracts on diesel fuel, so it was not possible to hedge diesel fuel directly. Heating oil and diesel fuel, however, are highly correlated in market prices (.99 correlation). Thus, J & L can use heating oil to hedge. But what if there is a black swan event and the correlation between heating oil and diesel changes (The idea is similar to the problem that non-profit organizations had during the 2008 recession with the interest rates swaps). This is an extra risk for J & L to hedge using the heating oil futures. Risk management instruments from KCNB also were designed to use the average price of heating oil during the contract period. Furthermore, there are other extra fees and premium to use KCNB’s products. Also, if J & L happens to use NYMEX futures or KCNB’s custom fit futures, if the price drop further, J & L will be giving profit margins. If I can choose the percentage of 4.5 million gallons per month to hedge, I would choose to hedge about 50 percent. Although hedging can reduce the risk of rising diesel fuel prices, it still has its own downsides. Thus, in order to capture the advantages of both hedging and not hedging, and to avoid experiencing the worst case scenarios of both, I will decide to take both positions. 2. There are some advantages to purchase NYMEX contracts. They have very low transection costs. They are better for timing or allocation strategies, and it takes less time to...
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