You are the risk manager of an energy producing company. Your firm explores for and extracts crude oil. Your firm regularly produces approximately 50,000 barrels of oil monthly. You watch the energy markets closely and determine in early May 2011 that the current market price of $110 per barrel maybe a temporary peak.
Requirement
A: Construct both a futures and options hedge to lock in this $110 bbl price for the next 6 months. Be certain to specify contracts, quantities, dates and all relevant and pertinent information for this hedge, including the actions required to complete the hedge at the end of the time horizon.
B, Discuss the advantages and disadvantages of the futures and options hedging strategies in the above question. Be sure to discuss the important aspects of the two hedging strategies including, but not limited to, the capital requirements
Please note that we don't do students' assignments for them. Be sure to go back into your textbook or use a good search engine. http://hanlib.sou.edu/searchtools/
Once YOU have attempted to complete YOUR assignment, please re-post and let us know what you think. Then someone here will be happy to comment on your thinking.
A: To construct a futures and options hedge to lock in the $110 per barrel price for the next 6 months, we need to consider the contracts, quantities, dates, and other relevant information for both strategies.
1. Futures Hedge:
- Contract: NYMEX Crude Oil Futures Contract
- Quantity: Since your firm produces approximately 50,000 barrels of oil monthly, you would need to determine the number of contracts required to hedge your production over the next 6 months.
- Dates: Determine the specific contract expiration dates for the next 6 months and select the appropriate contracts.
- Action required at the end of the time horizon: If the market price remains higher than $110 per barrel, you can sell your futures contracts at the market price and lock in your profit. If the market price falls below $110 per barrel, you can purchase oil at the lower price and close out your futures contracts.
2. Options Hedge:
- Contract: NYMEX Crude Oil Call Options
- Quantity: Similar to the futures hedge, you would need to calculate the number of call options required to hedge your production.
- Dates: Determine the specific option expiration dates for the next 6 months and select the appropriate options.
- Action required at the end of the time horizon: If the market price remains higher than $110 per barrel, you can exercise your call options and lock in your profit. If the market price falls below $110 per barrel, you can choose not to exercise the options and purchase oil at the lower market price.
B: Advantages and Disadvantages of Futures and Options Hedging Strategies:
Advantages of Futures Hedge:
1. Simplicity: Futures hedging is relatively straightforward, as it involves entering into standardized contracts to buy or sell commodities at a predetermined price.
2. Greater liquidity: Futures markets are more liquid compared to options markets, allowing for easier entry and exit from hedging positions.
3. Lower capital requirements: Futures contracts often require lower upfront margin requirements compared to options contracts, making them more accessible for hedging purposes.
Disadvantages of Futures Hedge:
1. Limited price protection: A futures hedge locks in the price but does not provide any upside if the market price rises above the hedged price.
2. Obligation to fulfill the contract: With futures contracts, you are obligated to buy or sell the underlying commodity at a specific point in the future, regardless of market conditions or changes in your business needs.
Advantages of Options Hedge:
1. Upside potential: Call options provide the right, but not the obligation, to buy the underlying commodity at a predetermined price. This allows for potential profit if the market price increases significantly.
2. Protection from market downturn: If the market price falls below the predetermined strike price of the call options, you can choose not to exercise them and avoid additional losses.
Disadvantages of Options Hedge:
1. Premium costs: Unlike futures contracts, options contracts require the payment of a premium, which represents a cost upfront.
2. Complexity: Options trading involves understanding and selecting from various strike prices, expiration dates, and option strategies, which can be more complex than futures hedging.
When considering the capital requirements, futures hedging generally requires lower upfront costs (margin requirements) compared to options hedging, but options hedging would involve premium costs. Therefore, the specific capital requirements would depend on the current market conditions, contract quantities, and the particular options strategy chosen.