Derivatives Assignment

- Tried to present the rationale of Hedging Crude Oil by Oil Companies (RIL).
- How speculators trade using Synthetic Options on Crude Oil.

Reliance Industries Limited runs two Refineries located at Jamnagar, Gujarat . The capacities of these
two refineries are 33 Million and 27 Million respectively.
With little variability in the demand, the refineries are expected to run at rated capacity all through the
year. Crude is a major raw material and its price is the chief determinant on the refinerys profitability.
There has been a recent drop in the prices of Crude and Reliance would like to take advantage of the
drop to hedge itself against the future variations in the Crude Price.
The Refinery Capacity of 60 Million Tons can be divided equally to determine the monthly Crude
Requirements. The CMIE Option Prices of Crude for various Strike Prices and Months are given below
Since Hedging comes at a price, RIL would not like to Hedge the entire Quantity but would like to Hedge
60% of its requirement and would be bearing the price fluctuations of the remaining 40%. RIL decides to
Buy Call Options for 12 months starting from January 2015 at strike prices tabulated below.
Reliance has made some estimations of the expected average monthly price of Crude during these 12
months as given in the last column of the table, calculate the expected gains/ losses for 2014-15.

Month

Call price

Strike
Price

Put Price

Estimated
Price

Jan

1.82

66.5

1.51

78

Feb

3.17

66.5

2.77

78

Mar

4.14

66.5

3.61

78

Apr

4.8

66.5

4.07

80

May

4.97

66.5

4.03

80

Jun

6.06

66.5

4.95

80

Jul

5.68

67

4.95

82

Aug

6.14

67

5.27

82

Sep

6.64

67

5.58

82

Oct

7.12

67.5

6.37

84

Nov

5.51

67.5

4.53

84

Dec

7.49

67.5

6.24

84

Solution

Estimated
Spot Price

Option
Exercised and
Price applicable
per barrell

Price Paid
Extra over
$ 65

Price Paid
Less on
Estimated
Price

Total
Amount
Paid Over
$65

Total Savings
on Estimated
Spot Price

Month

Call price

Strike
Price

Jan

1.82

66.5

78

68.32

3.32

9.68

73.0068

212.8632

Feb

3.17

66.5

78

69.67

4.67

8.33

102.6933

183.1767

Mar

4.14

66.5

78

70.64

5.64

7.36

124.0236

161.8464

Apr

4.8

66.5

80

71.3

6.3

8.7

138.537

191.313

May

4.97

66.5

80

71.47

6.47

8.53

142.2753

187.5747

Jun

6.06

66.5

80

72.56

7.56

7.44

166.2444

163.6056

Jul

5.68

67

82

72.68

7.68

9.32

168.8832

204.9468

Aug

6.14

67

82

73.14

8.14

8.86

178.9986

194.8314

Sep

6.64

67

82

73.64

8.64

8.36

189.9936

183.8364

Oct

7.12

67.5

84

74.62

9.62

9.38

211.5438

206.2662

Nov

5.51

67.5

84

73.01

8.01

10.99

176.1399

241.6701

Dec

7.49

67.5

84

74.99

9.99

9.01

219.6801

198.1299

1892.0196

2330.0604

Thus we find that even though Reliance paid $ 1.892 Billion extra than what it would have paid had the
price of Crude been $65, it saved $2.33 Billion over what it would have paid had there been no Hedging.
Thus Hedging thru Call Options help companies like RIL to take advantage of the fall in Commodity prices
to fix their raw material prices and prevent it from market fluctuations.

Synthetic Options We can also see how speculators trade by taking call on the market movement by creating an option
synthetic. Suppose the January 2015 Call Option prices on Crude Oil are as per the Table Given Below
Strike

Call
66
67

2.12
1.56

68

1.11

The speculator expects the price to be range bound and does not foresee it increasing substantially.
He can create a Synthetic option by going long call on Strike price $66 and $68 and write 3 calls at Strike
Price of $67.
He spends $3.23 on going long on 2 calls and Gets $ 4.68 on wring the calls, If the Crude Price on Expiry
is P, his pay off matrix would look like
Price at the expiry
<66
66-67
67-68
>68

Pay Offs
$1.45
$1.45 + (P-66)
$2.45 2*(P-67)
$0.45 (P-68)

Thus as evident, he makes positive payoff as long as the price of the Crude does not exceed 68.45,
however once crude goes past 68.45, he starts losing money.