Question

Your firm will buy 470,000 barrels of oil three months from now. You hedge the oil price risk by buying oil call options that expire in three months. Each oil option contract is for 1,000 barrels. The option price is $6.50/ barrel. The exercise price is $55/barrel and the current spot price is $56/barrel. Find the total cost (including the hedge) of buying 260,000 barrels in three months if the spot price increases by 30%. What is the effective price per barrel? Explain why you are glad, or not glad, that you hedged. Show all steps including the payoff on the options.

Bill owns a building and wants to insure it for $5 million. He places $3.5 million with company A, $2 million with company B, and $0.3 million with company C. How much does he receive from each company if a $8 million loss occurs and there is a pro-rata liability provision in place? How much does he receive from each company if a $8 million loss occurs and there is a contribution by equal shares provision in place? show all work

A firm is insuring a house with an actual cash value of $200,000. They have insured this house for $185,000. How much would they receive from an insurer if a coinsurance clause is in place at the typical required rate and the loss is $175,000? How would the answer change if the house was insured for $150,000? show all work

Explain why ACV is determined by replacement cost minus depreciation for property. How does this relate to the principle of indemnity? How does this relate to the principle of subrogation?

Answer 1

(I Can only answer a single question at a time. Please post questions seperately)

So the firm wants to buy 470,000 barrels of oil three months from now. So you buy a call option to buy the oil after three months. The price of option is $6.5/barrel and single contract has 1000 barrels so you will be required to buy 470 contracts.

The Cost for Option will be $6.5 * 470 * 1000 = $ 3,055,000.

So the initial cost is $ 3,055,000 and the spot price today which is $55/barrel increases 30% i.e. 56 + 56 * 30% = $72.8/barrel.

As you have bought the option, on the day you need the oil, you will see that the exercise price of option is $55/ barrel while the spot price is too high. So you will execute the option and will buy 470,000 barrels of oil at $55

So you will get the oil at 470,000 * 55 = 25,850,000

So your total cost of entering the option nd buying the oil is $3,055,000 + $25,850,000 = $ 28,905,000

The Effective Cost per barrel is 28905000/470000 = $61.5/barrel

If you would not have entered the option and purchased the oil from spot market then you would have got it $72.8 So your total cost would be $72.8 * 470,000 = $ 34,216,000.

You would be glad that you entered the option as you saved (34,216,000 - 28,905,000) = $5,311,000