Holooly Plus Logo
Holooly Plus Logo

Question 20.ss.5: Your firm, which uses oil as an input to its production proc...

Your firm, which uses oil as an input to its production processes, hedges its exposure to changes in the price of oil by buying call options on oil at today’s price. If the price of oil goes down by the time the contract expires, what effect will that have on your company?

The blue check mark means that this solution has been answered and checked by an expert. This guarantees that the final answer is accurate.
Learn more on how we answer questions.

The effect on your company of the decline in the price of oil will be to increase earnings. This is because the oil is an input to your production process, and a drop in prices will reduce your expenses. If the price of oil goes down, you would let the call option expire without exercising it. Of course, the benefit your company receives from the drop in oil prices would be reduced by the amount that you paid to purchase the option.

Related Answered Questions

Question: 20.2

The Value of Real Options SITUATION: You work for a company that manufactures cardboard packaging for consumer product companies under long-term contacts. For example, your company manufactures the boxes for several popular cereal and aspirin products. You have just won a large five-year contract ...

Verified Answer:

DECISION: You should choose the labor-intensive al...
Question: 20.1

When It Makes Sense to Exercise an Option SITUATION: You own a call option and a put option on a share of Ford Motor Company stock. The exercise price for both of these options is $18 per share, and both options expire today. If the current price of Ford stock is $17, would you exercise either of ...

Verified Answer:

DECISION: You should exercise the put option. It a...
Question: 20.A.2

Valuing a Put Option PROBLEM: In Learning by Doing Application 20.1, we found that a call option on a share of Grote Agricultural Company stock is worth $8.77 when the stock price is $35, the exercise price is $30, the risk-free rate is 4 percent, and the time to maturity is 1 year. What is the ...

Verified Answer:

The value of the put option is as follows: ...
Question: 20.A.1

Valuing a Call Option PROBLEM: You are considering purchasing a call option on the stock of Grote Agricultural Company. Grote stock currently trades for $35 per share, and you predict that its price will be either $25 or $50 in one year. The call option would enable you to buy a share of Grote ...

Verified Answer:

With an exercise price of $30, the option will be ...
Question: 20.ss.1

Of the two parties to an option contract, the buyer and the seller, who has a right and who has an obligation? ...

Verified Answer:

The buyer (owner) of the option has the right to e...
Question: 20.ss.2

The stock of Augusta Light and Power is currently selling at $12 per share. Over the next year the company is undertaking a new electricity production project. If the project is successful, the company’s stock is expected to rise to $24 per share. If the project fails, the stock is expected to fall ...

Verified Answer:

First determine the payoffs for the stock, a risk ...
Question: 20.ss.4

Your company is considering opening a new factory in Europe to serve the growing demand for your product there. What real options might you want to consider in your capital budgeting analysis of the factory? ...

Verified Answer:

Several significant real options might be associat...