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 oil drilling project, determined to have a positive NPV. 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

The best choice for hedging the oil price risk while pursuing the positive NPV project is to purchase put options with a strike price of $130 on each barrel of oil expected to be produced. This strategy will allow the company to limit their potential losses if oil prices were to fall below $95 while also allowing them to benefit from any oil prices above $130. Selling call options (option B) would expose the company to unlimited losses if oil prices were to rise above $130, while purchasing call options (option A) would only provide protection for the downside risk and not offer any additional benefits if oil prices were to rise. Selling put options (option D) would expose the company to losses if oil prices were to fall below the strike price, which is the opposite of the company's goal to avoid financial distress.

Trerec Co Is a Privately Owned Oil Drilling and Refinery Company