Framer, if you are a user of a commodity, a hedge allows you to buy that commodity
in the future at a fixed price today.
In the example of an airline, you can go to the futures market and purchase a contract for delivery at some distant time & lock in a price- here's an example
Say you wish to consume 1000 barrels of oil in July 2012 & you wish to lock in a price today to allow you to plan with a known price. You go to the futures market -
crude futures chain and you will see a price of 102.73 (Jul 1 price, this will change). You purchase your contract and that
is the price you will pay per barrel in July 12. A future is an binding obligation to either buy or sell some commodity in the future, with the price locked in when the contract is made.
The mechanics of the futures market, however "mark to market" each day. Lets say that the July 2012 contract declines to exactly 100 tonight. this represents a 2.73 loss on that contract x 1000 barrels = $2730. This money is transferred out of your account at the close of business and into the account of the seller of the contract. In other words there is a daily mark to market transfer depending upon the settlement price
every day. Note also that you must deposit and initial margin prior to the purchase of the contract, and then a further maintenance margin to hold the contract over night.
However, there is another way to do this, you can purchase an option over the future, so you could purchase a July 2012 call option, for which you have the right, but not to obligation to purchase the July 12 futures contract at some point prior to July 12. For this you pay a premium.
For example, you could purchase a Jul 12 $100 call option, for which you pay a premium* - lets say the
option contract trades at $6.50. So, in this case at most you will pay
is 106.50 ($100 + $6.50) per barrel. Note the subtlety
at most, and the difference between the straight future which is you will pay 102.73 per barrel. Note, that the premium is a once off payment, and there is no margin requirement if you are buying, there is no nightly "mark to market". However, the value of the option contract could decline to 0 if oil declines well below 100 close to Jul 12.
(The reason you pay
at most 106.50 with the
option contract is because if oil declines to say $50, your option contract is worthless therefore you don't exercise it, but you can then go into the open market & purchase a contract or spot at $50, therefore you only pay $55.60 per barrel, however, the holder of the futures only contract will still pay 102.73 as they )
So, putting the clues together, my guess is that J* Pacific hedged somewhere near the top of the oil market using futures, not options. They then were required to pour large amounts of cash into their trading accounts to offset the daily mark-to-market with the oil price crash. Not only that, the exchange probably increased margins to protect the integrity of the exchange as the price and volatility increased, further increasing the cash required (This paper loss would eventually be offset by the purchase of the fuel physical fuel at a much lower price).
*The premium is the composed of the any intrinsic value + a premium for the time value of money, the volatility of the underlying contract & the length of time remaining, see the
Black Scholes Pricing Model for further details.