Trerec Co. is a privately-owned oil drilling and refinery company with a significant amount of debt. Most of the company's cash flows come from the financially stable refinery 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 positive-NPV oil drilling project. Because of the nature of oil prices, the project is very risky. At any oil price above $115, the project would add value to the company. However, if oil prices were to fall below $95 the losses could push the entire business into financial distress. Assume the risk-free interest rate is 0 percent. Which of the following strategies would allow the firm to pursue the positive NPV project while hedging the oil price risk?

Question

Quizplus · Accepted Answer

Purchasing put options with a strike price of $130 would allow the firm to hedge against the risk of falling oil prices. If oil prices do fall below $95, the firm can exercise the option and sell the oil at the higher strike price of $130, reducing the impact of the losses on the new drilling project. Selling call options, as in option B, would expose the firm to unlimited losses if oil prices rise above $130. Purchasing call options, as in option A, would provide some protection against rising oil prices but would not hedge against the risk of falling oil prices. Selling put options, as in option D, would expose the firm to unlimited losses if oil prices fall below $130.

Trerec Co Is a Privately-Owned Oil Drilling and Refinery Company with with a Significant