Reducing Risk with Options

Managers regularly buy options on currencies, inter­est rates, and commodities to limit downside risk. Consider, for example, the problem faced by the Mexican government. A hefty portion of its revenue comes from Pemex, the state-owned oil company. So, when oil prices fall, the government may be compelled to reduce its planned spending.

The government’s solution has been to arrange an annual hedge against a possible fall in the oil price. Although the details of its hedging program are a closely guarded secret, it is reported that in 2017 the Mexican government bought put options that gave it the right to sell about 250 million barrels of oil over the coming year at an exercise price of $46 per bar­rel. If oil prices rose above this figure, Mexico would reap the benefit. But if oil prices fell below $46, the payoff to the put options would exactly offset the revenue shortfall. In effect, the options put a floor of $46 a barrel on the value of its oil. Of course, the hedge did not come free. The Mexican government was said to have spent $1.25 billion to buy the con­tracts from a group of international banks.

Figure 26.1 illustrates the nature of Mexico’s insurance strategy. Panel a shows the revenue derived from selling 250 million barrels of oil. As the price of oil rises or falls, so do the government’s revenues. Panel b shows the payoffs to the govern­ment’s options to sell 250 million barrels at $46 a barrel. The payoff on these options rises as oil prices fall below $46 a barrel. This payoff exactly offsets any decline in oil revenues. Panel c shows the gov­ernment’s total revenues after buying the put options. For prices below $46 per barrel, revenues are fixed at 250 X $46 = $11,500 million. But for every dollar that oil prices rise above $46, revenues increase by $250 million. The profile in panel c should be familiar to you. It represents the payoffs to the protective put strategy that we first encountered in Section 20-2.

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.

2 thoughts on “Reducing Risk with Options

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