Question

In 1986 Standard Oil issued some bonds from which the holder received no interest. At
the bond's maturity the company promised to pay $1,000 plus an additional amount based
on the price of oil at that time. The additional amount was equal to the product of 170 and
the excess (if any) of the price of a barrel of oil at maturity over $25. The maximum
additional amount paid was $2,550 (which corresponds to a price of $40 per barrel).
These bonds provided holders with a stake in a commodity that was critically important
to the fortunes of the company. If the price of the commodity went up, the company was
in a good position to provide the bondholder with the additional payment. Show that the
Standard Oil bond described is a combination of a regular bond, a long position in call
options on oil with a strike price of $25, and a short position in call options on oil with a
strike price of $40.

Answer 1

The standard Oil bond described is a combination of a regular bond and a long position in call options for following reasons -

1. At the bonds maturity company is paying $ 1000 and not paying any interest on it means it is a zero coupon  bond.

2. The company is paying additional amount on the basis of price of oil at the time of maturity . If the price of oil is upto    $25 barrel the comapny will not pay any additional amount and if the price goes beyond $ 25 the company will pay 170x(Oil Price at the time of maturity- $25). Hence it a call option with strike price $25.

Note - It is not the short position in call option on oil with strike price 40 because it is clearly given in the question that the company paid maximum additional amount of $ 2550 (witch correspond to a price of $ 40 per barrel). Had it been a short postion in call option then at the price $ 40 company would not have paid any addition amount to bondholders.