Price Corridors

A price corridor is an options strategy that reduces but does not eliminate premiums by only capping prices up to a certain point. As with a traditional cap, a price corridor places a ceiling on price movements above a specific price. Under the price corridor strategy, however, prices are only capped up to a certain point, beyond which they are permitted to keep rising. If structured properly, this strategy reduces the premium payment required under a traditional cap-price options strategy and provides the buyer with adequate price protection under most price scenarios. However, the

Source: SAIC $1.50 $1.75 $2.00 $2.25 $2.50 $2.75 $3.00 $3.25 $3.50 10 11 12 13 14 15 16 17 18 19 20 1 2 3 4 5 6 7 8 9 21 22 23 24

Agency Price (incl. participation) Cap Price Floor Price Market Price Gains versus

market price

Losses versus market price

Time Unit

strategy does not give full protection under extreme price scenarios. Figure 4.6 shows how the price corridor would perform versus the market over a 24-month period given a hypothetical range of market prices.

4.1.5 Advantages

The biggest advantage of cap-price instruments over forward-price instruments is that they permit greater flexibility to customize a transit agency’s fuel price risk profile. Forward contracts simply lock-in a price over a set period of time and provide profit when prices go up and losses when prices go down. By contrast, cap-price instruments, such as those that can be created with options, allow transit agencies to limit exposure to upward price risk while at the same time benefit from favorable, downward price movements. Although this win-win risk profile requires a premium, it allows transit agencies to more carefully customize their hedging strategies to their operations. Additionally, innovative use of options strategies can reduce or eliminate premium requirements.

The ability to take advantage of falling prices is an important consideration for transit agen- cies. Often, a transit agency must report to and be held accountable to its board of directors, state and local governments, and the greater public. Many of these stakeholders do not fully understand why an agency chooses to hedge its fuel prices and are suspicious of the financial instruments used to hedge. If these stakeholders learn that the agency is significantly overpaying for its fuel compared to the market price, support for the agency’s hedging program may waver. Hedging with options that allow an agency to take advantage of falling prices can help a transit agency avoid public backlash and encourage continued support for the hedging program. Source: SAIC $1.50 $1.75 $2.00 $2.25 $2.50 $2.75 $3.00 $3.25 $3.50 10 11 12 13 14 15 16 17 18 19 20 1 2 3 4 5 6 7 8 9 21 22 23 24

Agency Price (inlc. participation) Purchased Cap Price Sold Cap Price Market Price Losses versus market price Gains versus

market price

Time Unit

Hedging with options avoids adverse basis risk (see Info Box: Basis Risk), even if the options used are based on a price index that does not always closely track local prices. Adverse basis risk is less of an issue with call options because options contracts never lose and can only pay out money when exercised.

Like all financial hedging instruments, options can be bought and sold independently of the physical fuel contract, thus allowing the agency to continue its best practices for fuel procurement.

4.1.6 Disadvantages

Hedging with options is an extremely costly alternative. Several agencies interviewed for this guidebook had considered cap strategies at some point, but decided against them due to their extremely high cost relative to other hedging strategies. Options prices are driven by several factors (see Info Box: Options Pricing). A 12-month-forward, European-style call option in a moderate volatility price environment could cost roughly 10 cents per gallon, compared with fees of 0.1 to 0.15 cents per gallon for futures contracts and 1 to 5 cents per gallon for OTC swap contracts with similar maturities. Furthermore, call options typically require premiums to be paid upfront on all the contracts purchased. Funding this large, upfront cash premium may be a difficult task for a transit agency if cash is not readily available. However, premium costs for cap-price instruments can be reduced or eliminated through the use of innovative cap-price products, such as collars, participating caps, and price corridors.

A related disadvantage is that premiums for long-dated call options are much more expen- sive than those for short-term options, which limits the time horizon over which an agency can affordably hedge its fuel consumption. Even in low volatility price environments, longer-dated options are expensive because they give volatility more time to work. The buyer of an option can only benefit from increased volatility because it increases the probability that the option will be in-the-money at maturity. This heavy premium on longer-dated call options makes it impractical to use options strategies for longer-term hedging strategies.

Although no-cost options strategies, such as collars and participating caps, could theoretically eliminate some of the cost-related disadvantages of hedging with options, no transit agency interviewed for this guidebook has had experience employing them. This may be due to the inherent complexity of hedging with options. Some hedging advisers that work with transit agencies believe that options are generally good products for hedging in terms of the risk pro- files that they allow the buyer to create, but believe that employing such strategies is difficult in practice. Many transit agencies are suspicious of complexity and prefer hedging with more straightforward instruments such as futures or swaps. Some transit agencies interviewed for this guidebook expressed interest in using option strategies, but wanted to see how their experience with futures or swaps fared before moving on to more complex instruments.

4.1.7 Summary

Table 4.1 summarizes the main advantages and disadvantages of hedging with over-the- counter options.