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An airline expects to purchase 2 million gallons of jet fuel in 1 month and decides to use heating oil futures for hedging.

The variance of the heating oil futures price is 1,5 times bigger then the variance of the price of the jet fuel. The correlation between the spot jet fuel price and the 3 month heating oil futures price is 0.5.

Question a) Does the airline take a long or a short position in the futures contract?

Am in long or short position in oil heating futures? The answer is long, in my book, but I don't understand why.

I am in long in jet fuel, so why am I also long heat oil?

Can someone explain, how this works? Thank you!

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  • $\begingroup$ It depends on how heating oil and jetfuel are correlated in their example. Can you post the full question? $\endgroup$ – Drew Dec 15 '14 at 14:27
  • $\begingroup$ @Drew The question is in my native language, so I tried to translate it. $\endgroup$ – user010010001 Dec 15 '14 at 14:37
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This is a much simpler problem than stated, (assuming the correlation is positive).

In 1 month you need to BUY 2mn of jet fuel.

If Jet fuel prices go up, you lose money as it's more expensive. If jet fuel prices go down, you make money as it's cheaper.

So to "hedge" your risk you will LONG the heating oil, as you are not in the business of speculating on oil prices, to lock in your margins. So regardless of where prices of jet fuel go, the margins are preserved.

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