CORPORATE FINANCE | POSTED BY: ISWAN SHAH
Mitsubishi Bhd. (MB) must purchase jet fuel in three months for use in its operations. MB’s management has estimated that if the price of jet fuel were to rise above RM1,530 per barrel, the company would go bankrupt. The current price of jet fuel is RM1,450 per barrel. The company’s chief financial officer believes that the price of jet fuel will either rise to RM1,605 per barrel or fall to RM1,340 per barrel over the next three months. The management wishes to eliminate any risk of the company going bankrupt. MB can borrow and lend at the risk-free EAR of 6.50 percent.
Required:
1. Advise the company on whether to buy a call option or a put option on jet fuel, and avoid bankruptcy, determine the strike price and time to expiration of the option.
2. Calculate the price of the option should be sold in the open market.
3. Assuming that there are no options currently trade on jet fuel, suggest a way for the company to create synthetic option with identical payoffs to the option described in a.
4. Calculate the price of the synthetic option and compare with the price of the actual option. Comment on your answer.