Drunken Sailor Oil Corporation is negotiating the purchase of 1 million barrels of oil to be...

Drunken Sailor Oil Corporation is negotiating the purchase of 1 million barrels of oil to be delivered and paid for in exactly 1 year. Drunken Sailor Oil Corporation is willing to pay $25 per barrel because they can sell the oil in advance to oil refineries. For political reasons, the oil exporter wants the contract expressed in Danish kroner.

What price per barrel of oil expressed in Danish kroner is equivalent to $25 if the Danish krone exchange rate is $0.25?
If the contract is signed at a price of 110 Danish kroner per barrel and the oil corporation does not use futures contracts, in terms of U.S. dollars how much will it pay for the 1 million barrels of oil if the exchange rate per Danish kroner rises to $0.30?
If the oil corporation buys the Danish kroner in the futures markets for $0.26, how much will the oil cost in U.S. dollars (if the price of the oil was 110 kroner)?

Returning to Drunken Sailor Oil Corporation in the problem above. :

If the oil corporation locks in an exchange rate of $0.26 per Danish krone but the exchange rate falls to $0.20 at the end of the year, how much money will the firm have lost due to its decision to use futures contracts?
If the oil corporation locks in an exchange rate of $0.16 per Danish krone and the exchange rate rises to $0.25 at the end of the year, how much money will the firm have gained due to its decision to use futures contracts?

Expert Solution

price per barrel of oil expressed in Danish kroner = $25/$0.25 = 100 Danish kroner

1 Danish kroner is equal to $0.25. So, Danish kroner units will be more than dollar units.

Payment for 1 million barrels of oil = (1,000,000*110 Danish kroner)*$0.30 per Danish kroner = 110,000,000*$0.30 = $33,000,000

So, Payment for 1 million barrels of oil would be $33,000,000 in U.S. dollars.

Oil cost in U.S. dollars = (1,000,000*110 Danish kroner)*$0.26 per Danish kroner = 110,000,000*$0.26 = $28,600,000

Oil will cost $28,600,000 in U.S. dollars if the oil corporation buys the Danish kroner in the futures markets for $0.26.

Money lost due to its decision to use futures contracts = (1,000,000*110 Danish kroner)*($0.26 - $0.20) = 110,000,000*$0.06 = $6,600,000

Money gained due to its decision to use futures contracts = (1,000,000*110 Danish kroner)*($0.25 - $0.16) = 110,000,000*$0.09 = $9,900,000

jeff jeffy answered 7 months ago

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