We have to buy 1million barrels of oil in one year. The spot rate is 109.67 and the forward rate in one year is 115.03. We look in the paper and find the cost of call options are (per barrel):
Strike premium
125 USD 2.00
115 USD 8.00
105 USD 18.00
1. If you hedge with a forward, how much will the oil cost you?
2. If you instead decide to hedge with options, how much would you be paying for the optionality feature?
3. Suppose your best estimate of the probability you'll need to cancel the oil purchase is 25%. If it's cancelled, you'll lose 5% of value of the oil because you'll have to buy and sell back oil you don't need. Should you hedge the risky transaction with forwards or options? Why?