Collar hedge: Using the NYMEX Crude Oil Call and Put information in the Appendix
ID: 1175734 • Letter: C
Question
Collar hedge: Using the NYMEX Crude Oil Call and Put information in the Appendix, answer the questions below.- Is it possible to construct a zero-cost collar (at least within one cent net paid per barrel) on the collar hedging strategy?
- Why do firms use collar hedging strategies?
- If you were a refiner using a collar strategy, how would you hedge to have price protection? Explain the hedging strategy APPENDIX CRUDE OIL CALL OPTIONS FOR NYMEX WTI CRUDE OIL Prices are for March 17, 2012. The spot price for WTI crude oil was at $107.06 per bbl. OR EXERCISES IN THIS CHAPTER, USE THE PRIOR SETTLE PRICE AS THE OPTION PREMIUM Strike Price Type Last Change Prior Settle High Low Volume 14.33 13.86 13.39 12.92 12.45 11.99 11.52 11.07 10.62 10.17 9.73 9.29 734 100 399 728 434 100 761 347 759 724 217 CALL CALL _ CALL _ 9350 9400 9450 9500 9550 9600 9650 CALL CALL _ CALL- CALL _ CALL CALL- CALL- CALL- CALL- 9800 9850 9900 Continued)
Explanation / Answer
A collar hedge is essentially when an investor who is long on an asset is looking to protect the downside by purchasing out of the money put option and subsidises the cost of the put option purchase by selling an out of the money call option. If the asset price falls below the strike price of the put, the investor is protected and if the asset price goes above the call strike price the investor will have to let go of the gains beyond this level.
We are given the current per barrel price of $107.06. The refiner would want to protect the downside and 1% band on the per barrel price will be 105.99 to 108.13. This will require buying put option at 105.5 or 106 (105.99 is not available) and selling call at 108 or 108.50. The prices of put at 106 is 2.41 and call at 108 is 2.87 and at 108.5 it is 2.63. Thus even if we use 106 put and 108.50 call, we will still have a deficit of $ 0.22 per barrel. Hence a perfect zero cost collar in 1 % band will not be possible.
As explained above the collar hedge is quite useful when an investor who is long on an asset is looking for downside protection and low cost. So if there is a refiner who is producing oil and believes that the oil prices have run up a bit and may not be moving up sharply much but there may be downside risk to price can use collar hedge as below: