Reducing Risk with Options

In the last chapter we introduced you to put and call options. Managers regularly buy options on currencies, interest rates, and commodities to limit their downside risk. Many of these options are traded on options exchanges, but often they are simply private deals between the corporation and a bank.

Petrochemical Parfum, Inc., is concerned about potential increases in the price of heavy crude oil, which is one of its major inputs. To protect itself against such increases Petrochemical buys 6-month options to purchase 1,000 barrels of crude oil at an exercise price of $20. These options might cost $.50 per barrel.

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If the price of crude is above the $20 exercise price when the options expire, Petrochemical will exercise the options and will receive the difference between the oil price and the exercise price. If the oil price falls below the exercise price, the options will expire worthless. The net cost of oil will therefore be

Oil Price, Dollars per Barrel

Cost of 1,000 barrels $18,000 $20,000 $22,000

-Payoff on call option _0 _0 2,000

You can see that by buying options Petrochemical protects itself against increases in the oil price while continuing to benefit from oil price decreases. If prices fall, it can discard its call option and buy its oil at the market price. If oil prices rise, however, it can exercise its call option to purchase oil for $20 a barrel. Therefore, options create an attractive asymmetry. Of course, this asymmetry comes at a price—the $500 cost of the options.

► example 25.1 Hedging with Options

Consider now the problem of Onnex, Inc., which supplies Petrochemical with crude oil. Its problem is the mirror image of Petrochemical's; it loses when oil prices fall and gains when oil prices rise.

Onnex wants to lock in a minimum price of oil but still benefit from rising oil prices. It can do so by purchasing put options that give it the right to sell oil at an exercise price of $20 per barrel. If oil prices fall, it will exercise the put. If they rise, it will discard the put and sell oil at the market price:

Oil Price, Dollars per Barrel

Revenue from 1,000 barrels $18,000 $20,000 $22,000

Net revenues_$20,000 $20,000 $22,000

If oil prices rise, Onnex reaps the benefit. But if oil prices fall below $20 a barrel the payoff of the put option exactly offsets the revenue shortfall. As a result, Onnex realizes net revenues of at least $20 a barrel, which is the exercise price of the put option.

Once again you don't get something for nothing. The price that Onnex pays for insurance against a fall in the price of oil is the cost of the put option. Similarly, the price that Petrochemical paid for insurance against a rise in the price of oil was the cost of the call option. Options provide protection against adverse price changes for a fee—the option premium.

Notice that both Petrochemical and Onnex use options to insure against an adverse move in oil prices. But the options do not remove all uncertainty. For example, Onnex may be able to sell oil for much more than the exercise price of the option.

Brealey-Myers: I VIII. Special Topics I 25. Risk Management I I © The McGraw-Hill

Fundamentals of Corporate Companies, 2001

Finance, Third Edition chapter 25 Risk Management 725

FIGURE 25.1

Onnex can buy put options to place a floor on its overall revenues.

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Figure 25.1 illustrates the nature of Onnex's hedge. Panel a shows the total revenue derived from selling the 1,000 barrels of oil. The firm is currently exposed to oil price risk: as prices fall, so will the firm's revenue. But, as panel b illustrates, the payoff on a put option to sell 1,000 barrels rises as oil prices fall below $20 a barrel, and therefore can offset the firm's exposure. Panel c shows the firm's net revenues after it buys the put option. For prices below $20 per barrel, revenues are $20,000. But revenues rise

Figure 25.1 illustrates the nature of Onnex's hedge. Panel a shows the total revenue derived from selling the 1,000 barrels of oil. The firm is currently exposed to oil price risk: as prices fall, so will the firm's revenue. But, as panel b illustrates, the payoff on a put option to sell 1,000 barrels rises as oil prices fall below $20 a barrel, and therefore can offset the firm's exposure. Panel c shows the firm's net revenues after it buys the put option. For prices below $20 per barrel, revenues are $20,000. But revenues rise

Brealey-Myers: I VIII. Special Topics I 25. Risk Management I I © The McGraw-Hill

Fundamentals of Corporate Companies, 2001

Finance, Third Edition

726 part eight Special Topics

$1,000 for every dollar that oil prices rise above $20. The profile in panel c should be familiar to you: think back to the protective put strategy we first saw in Example 24.1. In both cases, the put provides a floor on the value of the overall position.

► self-test 25.1 Draw three graphs like those in Figure 25.1 to illustrate how Petrochemical hedges its costs by purchasing call options on oil.

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