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 percent. Which one of the following strategies would allow the firm to pursue the positive-NPV project while hedging the oil price risk?

Question

Quizplus · Accepted Answer

By purchasing put options, the firm can protect itself against potential losses from falling oil prices. If oil prices fall below $90, the put options will provide a payoff to the firm which will offset the losses from the project. If oil prices remain above $110, the put options will expire worthless and the project will add value to the company. Selling call options (Option B) would expose the company to potential losses if oil prices rise above $120, which could result in financial distress. Purchasing call options (Option A) would provide protection against losses if oil prices rise, but would not protect against losses if oil prices fall below $90. Selling put options (Option D) would expose the company to potential losses if oil prices fall below $120.

Risk Management: OilDog Co