Question
Consider an oil distributor planning to sell 1 5million barrels of oil in one year wishes to hedge against a possible decline in oil prices.
Consider an oil distributor planning to sell 1 5million barrels of oil in one year wishes to hedge against a possible decline in oil prices. Assume the variable cost of producing oil is $40 per bsrrel and the fixed cost ( including interest expense) equals to $150 million. The current market price for the oil is $58 per barrel. Suppose in one year, the oil price will be most likely in the range of $47 per barrel to $60 per barrel.The firm also borrows $100 million in terms of 6% annual fixed rate bank loans (i.e. the annual interest expense are $6 million).The lender requires the firm to have at least twice as much in EBIT (i.e. earning before interest and taxes)as the interest expenses(i.e. the interest coverage ratio or EBIT/I should be 2 or higher). The annualized risk-free interest rate is 3.45%. Ignore any commission fees or storage fees for oil. In considering various hedging strategies, the firms risk manager is setting the objective to minimize the chances that the firm will not have enough gross profits to maintain the interest coverage ratio equaling to or above 2. Please answer that with the forward contract, if the firm needs only partial hedging, which of the following is closest to quantities of oil the firm should hedge using the forward contract (in million of barrels)? a)3.812 b)4.385 c)4.562 d)4.695 e)none of the above
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