Suppose there is an options market in SO2 permits, where each permit entitles on

Question

Suppose there is an options market in SO2 permits, where each permit entitles one ton of SO2 emissions. Suppose that running a scrubber costs $65 per year per ton of SO2 removed, has a capital cost of $30,000,000, and an expected life of five years. Then a utility that needs to remove 40,000 tons of SO2 per year should install the scrubber if

(a) the sum of the costs of 40,000 one, two, three, four, and five year call options each with a strike price of $65 is less than $30,000,000.

(b) the sum of the costs of 40,000 one, two, three, four, and five year call options each with a strike price of $65 is more than $30,000,000.

(c) the sum of the costs of 40,000 one, two, three, four, and five year put options each with a strike price of $65 is less than $30,000,000.

(d) the sum of the costs of 40,000 one, two, three, four, and five year put options each with a strike price of $65 is more than $30,000,000.

Explanation / Answer

(a) the sum of the costs of 40,000 one, two, three, four, and five year call options each with a strike price of $65 is less than $30,000,000.

Firm will install scrubber if cost of 40,000 five years options value is less than the $ 30,000,000. So, firm will buy call option with a strike price of $ 65.

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