It is March, and Alberta Oil Refinery (AOR) has enough crude oil in inventory to continue refinery operations until September. AOR expects to need to purchase

400,000

barrels of oil in September. Management at AOR is concerned about oil price volatility. Futures contracts for September delivery are available with a futures price of

$120

per barrel. Options contracts with a strike price of

$120

and expiration in September are also available; puts cost

$25

and calls cost

$20.

Complete parts a through e.

a.

Describe how AOR can fully hedge using oil futures contracts.

A.

AOR can wait until prices rise in the future.

B.AOR can hedge by taking a short position in futures for

400,000

barrels of oil for September delivery.

C.AOR can hedge by taking an intermediate position in futures for

400,000

barrels of oil for September delivery.

D.AOR can hedge by taking a long position in futures for

400,000

barrels of oil for September delivery.

c. Describe how AOR can fully hedge using options.

A.AOR can sell the call options on

400,000

barrels of oil.

B.AOR can purchase the call options on

400,000

barrels of oil.

C.AOR can purchase the put options on

400,000

barrels of oil.

D.AOR can sell the put options on

400,000

barrels of oil.

d. Given the strategy in

c,

what will be the total net amount paid by AOR (for all

400,000

barrels) if the price of oil in September is as follows:

i.

$70

per barrel; ii.

$120

per barrel; iii.

$170

per barrel

i.

$70

per barrel; the total net amount paid by

AOR=$nothing

million.

ii.

$120

per barrel; the total net amount paid by

AOR=$nothing

million.

iii.

$170

per barrel; the total net amount paid by

AOR=$nothing

million.

(Round to the nearest million dollars.)

e. AOR has asked for your advice regarding hedging. Discuss how the each of the following individually will influence your advice.

i. AOR does not expect to have much cash available between April and August. In this case, AOR will choose to

the futures hedge.

ii. AOR thinks that a drop in oil prices will occur if the economy goes into recession. There is a 33% chance this will happen. In a recession, demand for AOR's refined oil products will drop by half. In this case, AOR should choose

the options hedge.

the futures hedge.

no hedge.

iii. AOR will experience extreme financial distress costs if its net revenues in August do not cover the net costs of oil purchased then. AOR net revenues are estimated to be

$70

million. In this case, AOR should choose

the options hedge.

no hedge.

the futures hedge.

iv. AOR will experience extreme financial distress costs if its net revenues in August do not cover the net costs of oil purchased then. AOR net revenues are estimated to be $50 million. In this case, AOR should choose

the options hedge.

no hedge.

the futures hedge.

v. AOR can pass along any price increases in oil by increasing the prices of its refined products. In this case, AOR should choose

the options hedge.

the futures hedge.

no hedge.