Drywell Limited is a USD-based oil company producing one million barrels of oil in Tunisia every...

 

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Drywell Limited is a USD-based oil company producing one million barrels of oil in Tunisia every year. The annual sales revenue depends on the world oil price. Drywell's cash-flow need for exploration and development (E&D) activities is determined by the oil price level: CF Need for E&D = $15,000,000+ 670,000 x $Oil Price Drywell's risk management objective is to generate enough cash needed for the exploration and development (E&D) activities. The current oil price is USD80 per barrel. It is expected to remain highly volatile with annual standard deviation standing at 25%. Drywell is considering using oil futures to achieve its risk management objective. The oil futures price now is USD85 per barrel and fluctuates with annual standard deviation equal to 23%. The correlation coefficient between the spot oil price and the futures price is equal to 0.95. As the risk analyst of Drywell Limited, you are to recommend an optimal hedging strategy for achieving its risk management objective. (a) How many barrels in oil futures should be used for the optimal hedge? (15 points) (b) What if the spot and the futures oil price today are respectively $30 and $31 respectively and are expected to stay at the same level for the foreseeable future with all other factors remaining the same? (5 points) Drywell Limited is a USD-based oil company producing one million barrels of oil in Tunisia every year. The annual sales revenue depends on the world oil price. Drywell's cash-flow need for exploration and development (E&D) activities is determined by the oil price level: CF Need for E&D = $15,000,000+ 670,000 x $Oil Price Drywell's risk management objective is to generate enough cash needed for the exploration and development (E&D) activities. The current oil price is USD80 per barrel. It is expected to remain highly volatile with annual standard deviation standing at 25%. Drywell is considering using oil futures to achieve its risk management objective. The oil futures price now is USD85 per barrel and fluctuates with annual standard deviation equal to 23%. The correlation coefficient between the spot oil price and the futures price is equal to 0.95. As the risk analyst of Drywell Limited, you are to recommend an optimal hedging strategy for achieving its risk management objective. (a) How many barrels in oil futures should be used for the optimal hedge? (15 points) (b) What if the spot and the futures oil price today are respectively $30 and $31 respectively and are expected to stay at the same level for the foreseeable future with all other factors remaining the same? (5 points)