The current oil pricing curve looks like this: Jan $52.00 per barrel Feb $53.25

Question

The current oil pricing curve looks like this:

Jan $52.00 per barrel

Feb $53.25 per barrel

Mar $54.55 per barrel

You elect to hedge Jan and Feb by a straight swap (floating for fixed rate) and Mar by purchasing an option.

The premium for a Mar18 option Call is: $1,000 per 1000 barrels.

The premium for a Mar18 option Put is:   $500 per 100 barrels.

On Mar 31,2018, the spot price of a barrel of oil drops to $38.75. Do you exercise your option? What is the net dollar settlement of the option if exercised?

Explanation / Answer

Answer:

This is a straight SWAP options in which there is an option to enter into an agreement without having any obligation to exercise the option. Only premium shall be charged on a per barrel basis if option is not exercised.

Current Price:    $ 54.55 per barrel.

Premium:    $ 500 per 100 barrel.

Spot Price:    $ 38.75 per barrel.

We need to hedge at a particular value. In case, current price > exercise price, we shall exercise option after paying premium and shall incur gains otherwise loss is to the tune of premium. In this case, if $54.55 per barrel is a contract price then we shall exercise the option from the spot market and gain $10.80 per barrel ($54.55 per barrel - $38.75 per barrel - $5.0 per barrel).

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