Certain market situations or attitudes to risk by company executives require instruments with more flexibility then a swap.
Rather than locking in a particular bunker price for a defined time period, a hedger may prefer to retain some exposure to fuel prices while setting an upper limit, beyond which he would be unwilling to pay.
A cap (or call option) is a financial instrument which protects a business from rising fuel prices whilst allowing it the flexibility to take advantage of falling prices.
A simple way to view it would be as an insurance contract. You pay a premium to the seller of the contract and he insures you against fuel prices that are above a predefined level.
Select the most relevant contract (e.g. US Gulf Coast No.6 Fuel Oil 3%)
Select volume of fuel to hedge
Select time period
Select price cap level (or strike price)
(This example uses Monte Carlo simulated data assuming 30% volatility and a Fuel Oil index starting at an execution price of 100.)
Scenario 1: Fuel price remains below cap level (un-shaded zone). There are no further cash payments or receipts. Physical fuel is purchased in the market and the company is able to take advantage of falling prices.
By using a cap, the commercial hedger has set a maximum fuel price he will pay for bunkers over the time period he selected
Scenario 2: Fuel price rises above cap level (green zone). The company receives cash from its trading counterparty to offset the higher physical fuel prices that it must pay in the market.
By using a cap, the commercial hedger has set a maximum fuel price he will pay for bunkers over the time period he selected.
The cap level chosen may be the fuel price at which the company becomes unprofitable.
A different scenario may be the company effectively insuring themselves against financial distress. The cap level selected would be protection against an extreme price spike that threatened the company's ability to continue operations.
There are many ways to structure this type of hedge. Different market conditions require different strategies, and different companies have different objectives they are trying to achieve.
The optionality provided by a cap allows executives additional flexibility relating to their budgetary and risk management decisions.
Christopher Cheetham is the President and Co-founder of Soter Advisors Ltd