This is from exam 2 in the fall of 2010
1.(56 points total) Suppose you are in charge of an oil refinery which means you, as in your firm, are a user of crude oil and a producer of gasoline. As we know, both crude oil and gasoline are part of a well developed financial market so that futures and futures options markets exist that are extremely liquid for these two commodities. Suppose that you know next to nothing about markets and so you need to hire someone to help you make decisions as to how to the ‘play the game’ and maximize profits. Naturally, you maximize profits by minimizing the cost of the input…oil … and maximizing your revenue…..selling gas. We assume away all costs except for the input oil and we have the following production figures – each oil contract consists of 1000 barrels of crude and with 1000 barrels we can produce 100,000 gallons of gas. Each gas contract is for 50,000 gallons so for every oil contract that we buy we produce the equivalent of two gasoline contracts. We have a contract with BP for 500,000 gallons of gasoline for delivery at the end of February 2011 (10 gasoline contracts worth) and we need to buy the oil (5 contracts), the input, at the end of November to give us time to refine it in time for delivery. The charts below represent the two futures contracts we consider – the Dec 2010 oil contract that expires on 11/19/10 and the March 2011 gasoline contract that expires on 2/28/2011.
Four different job applicants come in and you interview them….they all advise you a little differently.
1) Future guy – this person simply plays the futures market – so they would advise you buy oil futures and to sell gas futures.
2) Going naked – this person doesn’t hedge and would advise you to take your chances in the spot market – think of this person as having a high risk appetite.
3) The option buyer – this person would advise you to buy futures options calls on oil and futures options puts on gas.
4) The option writer – this person would advise you to write futures options puts on oil and to write futures options calls on gas.
We consider the oil market first (see graph below). Suppose that the futures price of oil is $80 per barrel and that futures options, both puts and calls, are available at a price of $2,000 each (STRIKE PRICE = $80, EACH CALL AND PUT REPRESENTS ONE FUTURE CONTRACT).. We consider two different scenarios with regard to this oil market and you need to figure out which of the job applicants have the best strategy given each scenario.
Scenario #1: The spot price of oil is $80 per barrel at expiration. Recall, you need to buy 5 contracts or 5000 barrels of oil to make the gas.
a) (9 points) Given Scenario #1, which of the four strategies is the best in terms of minimizing the cost of obtaining the 5000 barrels of oil and which strategy is the worst in terms of the costs of obtaining the oil? Be specific and provide the costs associated with each strategy for full credit. , Please use real numbers and show all work!
Scenario #2: The spot price of oil is $75 per barrel at expiration. Recall, you need to buy 5 contracts or 5000 barrels of oil to make the gas.
b) (9 points) Given Scenario #2, which of the four strategies is the best in terms of minimizing the costs of obtaining the 5000 barrels of oil and which strategy is the worst in terms of the costs of obtaining the oil? Be specific and provide the costs associated with each strategy for full credit. , Please use real numbers and show all work!
We now consider the market for gasoline (see graph below). Suppose that the futures price of gasoline is $2.00 per gallon and that futures options, both puts and calls are available at a price of $4,000 each (STRIKE PRICE = $2.00, EACH CALL AND PUT REPRESENTS ONE FUTURE CONTRACT). . We consider two different scenarios with regard to this gasoline market and you need to figure out which of the job applicants have the best strategy in terms of maximizing revenue, given each scenario.
Scenario #1: The spot price of gasoline is $2.00 per gallon at expiration. Recall, you need to sell 10 contracts or 500,000 gallons (10 X 50,000) of gas to sell to BP.
c) (9 points) Given Scenario #1, which of the four strategies is the best in terms of maximizing your revenue and which strategy is the worst in terms of revenue. Be specific and provide the revenue associated with each strategy for full credit. , Please use real numbers and show all work!
Scenario #2: The spot price of gasoline is $2.20 per gallon at expiration. Recall, you need to sell 10 contracts or 500,000 gallons (10 X 50,000) of gas to sell to BP.
d) (9 points) Given Scenario #2, which of the four strategies is the best in terms of maximizing your revenue and which strategy is the worst in terms of revenue. Be specific and provide the revenue associated with each strategy for full credit. , Please use real numbers and show all work!
Graphing – In the space below, please graph the futures and futures option profit function for the oil market given each Scenario (two diagrams – the bear on the left and the bull on the right). Recall, Scenario 1(LABEL AS POINTS A) is when the spot oil price is $80 per barrel at expiration and Scenario 2 (LABEL AS POINTS B) is when oil expires at $75 per barrel. Be sure to label diagram completely including the break even points! 10 points for completely labeled graph.
Graphing – In the space below, please graph the futures and futures option profit functions for the gasoline market given each Scenario (two diagrams – the bear on the left and the bull on the right) Recall, Scenario 1(LABEL AS POINTS A) is when the spot price of gasoline is $2.00 per gallon at expiration and Scenario 2 (LABEL AS POINTS B) is when the spot price of gasoline is $2.20 at expiration.. Be sure to label diagrams completely including the break even points! 10 points for completely labeled graph.
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