Reference no: EM133058508
You are employed by the Treasurer's office of Southwest Airlines. Your assignment is to help the Treasurer analyze possible hedging strategies for the firm's exposure to fluctuations in the price of oil. You have estimated that, without any hedging, the relationship between Southwest's expected next-year's operating cash flow and the price of oil (per barrel) in twelve months is given by the following relation.
Cash Flow = $2,200,000,000 - $50,000,000×(POil - $55) where POil is the price of a barrel of oil. Thus, they expect cash flows of $2.2 billion if the price of oil is $55/barrel. For every dollar increase of the price of oil, cash flows decline by $50 million.
Assume that you have the following 1-year European quotes for options on crude oil, quoted per barrel of oil, from a prestigious investment bank, Dewey, Cheatham, & Howe.
|
Strike price
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Call option price
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Put option price
|
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$50.00 / barrel
|
$7.47
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$1.97
|
|
$55.00 / barrel
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$4.64
|
$4.10
|
|
$60.00 / barrel
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$2.69
|
$7.10
|
|
$65.00 / barrel
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$1.46
|
$10.82
|
|
$70.00 / barrel
|
$0.76
|
$15.07
|
a) What is the least cost single option position they should take (which option, how many options, buy or sell) to guarantee cash flow of at least $1.7 billion, before the cost of the hedging program?
b) What is the cost of the hedging program in (a)?
c) What option positions should they take (which options, how many options, buy or sell) to eliminate all oil price risk and secure a cash flow of $1.7 billion, before the cost of the hedging program?
d) What is the cost of the hedging program in (c)? Is it higher or lower than the initial hedging program calculated in part (b)? Why?