Question
Option Pricing Assignment Figure 1 represents Dakota's current situation regarding the costs of allowances vs. scrubbers. Assume in this example that Dakota can purchase sufficient
Option Pricing Assignment Figure 1 represents Dakota's current situation regarding the costs of allowances vs. scrubbers. Assume in this example that Dakota can purchase sufficient allowances to handle its expected pollution. In other words, it is not in a situation where its total emissions exceed the number of allowances available. Consider the decision to install scrubbers to be irreversible. Note that the $200 scrubber cost is per ton of sulfur dioxide emissions, per year. This utility loses {has higher costs than otherwise) whenever the allowance price is less than the cost of scrubbing sulfur dioxide. The utility wins (has higher revenues) when allowance prices are greater than the cost of scrubbing. Figure 1. Scrubber cost vs. selling allowances 1. Dakota wants to eliminate the area of potential loss. If allowance prices fall below $200 per allowance, the scrubber installation will be uneconomical. What can they do to hedge against this possibility - buying or selling a call option, or buying or selling a put option? Superimpose this strategy on the above graph. What is the ending cost to the utility? Use the information and diagram in the case to answer these questions. 2. What are the five inputs needed in the Blade/Scholes option pricing formulas? How can these be related to allowance options? For example, in an ordinary options pricing problem, the underlying asset is a share of stock. What is the underlying asset in an allowance option-pricing problem?
Figure 1. Scrubber cost vs. selling allowances Reduction in utility costs through selling Costs in dollars Utility loses $200 Scrubber cost per ton per year Utility wins $200 Value of an allowance Figure 1. Scrubber cost vs. selling allowances Reduction in utility costs through selling Costs in dollars Utility loses $200 Scrubber cost per ton per year Utility wins $200 Value of an allowanceStep by Step Solution
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