Risk management: OilDog Co. is a privately owned oil drilling and hot dog producing company with a significant amount of debt. Most of the company's cash flows come from the very safe hot dog unit of the business. With only the assets in place, the company is very likely to avoid financial distress for the foreseeable future. Avoiding financial distress is very important to the owners, who founded the company. The company is considering a new oil field project, determined to have a positive NPV. Because of the nature of oil prices, the project is very risky. At any oil price above $110 the project would add value to the company. However, if oil prices were to fall below $90 the losses could push the entire business into financial distress. The risk-free interest rate is 0 per cent. Which one of the following strategies would allow the company to pursue the positive-NPV project while hedging the oil price risk?

Question

Quizplus · Accepted Answer

Option C involves purchasing put options with a strike price of $120 on each barrel of oil the company expects to produce. This means that if oil prices fall below $120, the company can exercise the put option and sell oil at $120, avoiding the losses that would push it into financial distress. The cost of each option is $5, which is a manageable expense for the company. Option A would involve buying call options, which provide the right but not the obligation to buy oil at a predetermined price. This would not provide effective hedging against falling oil prices. Options B and D involve selling options, which would leave the company exposed to significant losses if oil prices fell. Both options would not effectively manage the risk.

Risk Management: OilDog Co