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J and L Railroad Case Solution

Solution Id Length Case Author Case Publisher
2790 1578 Words (8 Pages) Jeannine Lehman, Kenneth Eades Darden School of Business : UVA-F-1053
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The Jackson and Lawrence train lines were combined to become the J&L Railroad, one of the biggest railways in the nation. J&L, regarded as a Class I railroad, ran around 2,500 miles of track across the West and Midwest. Additionally, J&L's revenue is reliant on the cost of diesel fuel because of the peculiarities of the railroad sector. In this respect, the company must determine how much of the anticipated fuel consumption for the upcoming year should be hedged and how to hedge it. The instruments such as NYMEX and KCNB can be used to set off some of the exposure. However, these alternatives have their downsides. As per exhibit 5, in this instance, heating oil and diesel fuel have a strong correlation of 0.99, rendering heating-oil futures an attractive hedging tool for diesel.

Following questions are answered in this case study solution

  1. Should J&L Railroad hedge all of its exposure to diesel fuel? What percentage of the 17.5 million gallons per month would you hedge? How did you arrive at this percentage?

  2. What are the pros and cons of using NYMEX contracts versus using the risk-management products offered by Continental Bank? Is the use of a monthly average price a net advantage or disadvantage to J&L? How can Continental hedge its side of the deal?

  3. Using the estimate of 17.5 million gallons per month, how would you construct a futures hedge for the following 12 months? How would you construct a commodity-swap hedge?

  4. Should Craft consider using an option-based hedge, i.e., caps, floors, collars, or corridors? Would you recommend that he reduce his overall hedging cost by using a collar or corridor? What strike prices you should use? Provide graphic illustrations.

Case Analysis for J and L Railroad Case Solution

1. Should J&L Railroad hedge all of its exposure to diesel fuel? What percentage of the 17.5 million gallons per month would you hedge? How did you arrive at this percentage?

Although J&L Rail Road might contemplate hedging, doing so for all of its exposure to diesel fuel is not advisable. The ideal hedge may not be attained in the foreseeable future since 17.5 million gallons of fuel is only a projected quantity. Since the demand is declining due to the recession of 2008, which affected fuel costs and lowered consumption, J&L must properly forecast future needs. The proportion of the 17.5 gallons would be hedged as J&L enters into future agreements with dealers at a set rate, and the amount they must hedge for gasoline costs should be approximately 2% since they need to retain inventories for future demand during the months of May, June and July of the year 2009. This percentage will increase depending on the demand as the year proceeds. The lesser demand is the reason why this proportion is smaller. Since the recession has been one of the extremely imperative factors that have significantly affected the consumption of diesel fuel, it is only fair that the future judgments are based on how J&L Railroad dealt with such similar circumstances in the past and then based their decisions to how they turned out in their favor.

2. What are the pros and cons of using NYMEX contracts versus using the risk-management products offered by Continental Bank? Is using a monthly average price a net advantage or disadvantage to J&L? How can Continental hedge its side of the deal?

Pros of NYMEX:

The upside of the NYMEX contract is that it offers a threshold to market exchange aptitude in which J&L's stance resided each day. This market-to-market constrained more toward reduced risk exposure as a 5% margin was considered necessary for the deal from both groups. Any rise and fall in the purchaser and seller's role were subtracted constantly.

Cons of NYMEX:

J&L Rail Road cannot employ diesel fuel hedging since NYMEX does not engage in fuel hedging agreements. As a result, J&L must first employ warming oil deals to hedge the diesel fuel exposure, resulting in a smaller exposure that is affected by the varying costs of these two commodity instruments. An additional issue with NYMEX agreements was the uniform contract format regarding maturity date and term size. Every heating oil contract had a 42,000-gallon delivery volume and reached maturity on the final business day of the previous month. Since the hedge would only be effective if the number of gallons being hedged was expressly acquired on the day the futures contract developed, J&L faced a maturity disparity. Also, because the number of gallons required in any given month was improbable to be easily quantifiable, 42,000 gallons, J&L encountered a size discrepancy.

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