The ABC Oil Company is exposed to the fluctuations of the crude oil price. The r
ID: 2810613 • Letter: T
Question
The ABC Oil Company is exposed to the fluctuations of the crude oil price. The risk profile of its net income for the current fiscal year as a function of the crude oil price (spot on March 15, 2001) is given in the graph. The company wishes to make its income independent of the crude oil price using the call options with various exercise prices. The contract size of the option is 1000 barrel of crude oil and the net income is in thousands.
A) What is the appropriate hedging strategy using call options?
B) What is the cash flow of the hedging strategy? Indicate whether or not the cash flows will be positive or negative for the ABC company.
C) What is the level of income with the hedging strategy?
Indicate your strategy?
The net cash flow required for the hedging?
Hedged income?
Exercise Price Option Premium Call Option #1 $10/bbl $11.00 Call Option #2 $15/bbl $6.50 Call Option #3 $20/bbl $5.00 Call Option #4 $25/bbl $3.00 Call Option #5 $30/bbl $1.00 Call Option #6 $35/bbl $0.75 Net Income $8,000 $7,000 $6,000 $5,000 $4,000 $3,000 $2,000$3,000 $1,000 7,000 $6,000 $6,000 $4,000 Net Income S0 $5 $10 $15 $20 $25 $30 $35 $40 $45 $50 $55 $60Explanation / Answer
ANSWER:
A) Appropriate hedging strategy for Comapny ABC: The Appropriate Hedging strategy for company ABC is to exercise the call option at $ 25 /bbl, where the company makes maximum net income of $ 7000. We presume that the net income projected in the graph is the net of option permium payable which is $ 3. This is the optimum profit the company can make by exercising call option 4. Beyong this option the excercise price is increasing and the difference between the exercise price and the market price does not appear to be very high and hence is resulting in reduction in the net income, as is visible from the graph.
B) The net cash flow rerequired for hedging at the above strategy i.e. call options 4 is $ 28,000
1000 barrels to be purchased at $ 25 = $25 X 1000 = $ 25000
Plus the amount needed for options premium is $ 3 = $3000.
Therefore the cashflow required for hedging is $ 28,000, to get the net income of $ 7,000, as is hown in the graph.
C) Hedging income at exercising the call option 4 given in the cell above is $ 7,000.
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