4.8. Hekinan Corporation has bought 4000 barrels of Brent crude oil $112.63 a ba
ID: 2712729 • Letter: 4
Question
4.8. Hekinan Corporation has bought 4000 barrels of Brent crude oil $112.63 a barrel. It has sold call options on 2000 barrels of oil, with exercise price $110, for $5.50 each; and options on 1000 barrels of oil, exercise price $115, for $1.80 each. All options will expire after 35 days and then Hekinan will liquidate this position. Hekinan expects the price of Brent crude after 35 days to be $114.50 a barrel. It uses 10% as the discount rate, with continuous compounding. Calculate the following the initial investment ($437,720), the final liquidation value ($449,000) and NPV of this investment ($6995.10). Show solutions.
Explanation / Answer
Price of 1 barrel = $112.63
Price of 4000 barrels = 4000 * 112.63 = $450520
Call option price with exercise price of $110 = $5.5
For 2000 barrels, price of call options = 5.5 * 2000 = $11000
Call option price with exercise price of $115 = $1.8
For 1000 barrels, price of call options = 1.8 * 1000 = $1800
Initial Investment = 450520 - 11000 -1800 = $437,720
After 35 days, price of 1 barrel = $114.50
Only options with strike price of $110 will get exercised since options with exercise price of $115 will be out of the money and will expire worthless.
Loss due to exercise of call options = (Expiration Price - Strike Price) * 2000 = (114.5 - 110) * 2000 = $9000
Since Heineken will liquidate its position,
Proceeds on sale of 4000 oil barrels that were originally bought = 114.5 * 4000 = $458,000
Final Liquidation value = 458000 - 9000 = $449,000
NPV of this investment with10% as the discount rate with continuous compounding
= - 437720 + 449000 * e-10% * 35/365
= - 437720 + 449000 e-0.009589
= - 437720 + 449000 * 0.990457
= - 437720 + 444715.0974
= $6995.10
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