OPTION PRICING OF CRUDE OIL: AN APPLICATION OF BLACK-SCHOLES MODEL

OPTION PRICING OF CRUDE OIL: AN APPLICATION OF BLACK-SCHOLES MODEL JamaladeenAbubakar Department of mathematics and statistics HussaainiAdamu Federal polytechnic, kazaure 08034067081, 07053555571 ajafuntua@yahoo.com NafiuBashirAbdussalam Department of Economics Bayero University, Kano 07037880962 Nafiu_bashir@yahoo.com

Introduction • Crude price fluctuation at the international market • Efforts made by governments to hedge the price fluctuation using derivative instrument • Forwards contract • Futures contract • Options contract • Swaps contract and • Caps and Floors contract

Introduction Cont……. • Option contract : are different from other derivative instruments because they give the option holders the right (but not the obligation) to buy an underlying asset at a specified price during an agreed period of time. • Types of Option • Call option which give the holder the right to buy • Put Option which give the holder the right to sell

Introduction Cont……. • Method of Exercising Option • American Option: this type of contract can be exercised at any time up to the expiry date • European Options: this contract can only be exercised at the expiry date . Option Trading position There are four basic option trading position • To buy a call

Introduction Cont……. Payoff Purchased call= Max(0, K-St) K St

Introduction Cont…… • ii) is to buy a put Purchased Put=Max(0, K-ST K 0 K St

Introduction cont iii) Is to sell a call Written Call= -Max(0, K-St) 0 St K

Introduction Cont….. iv) Written put=-Max(0, K-St) 0 St -K

Methodology • Black-Scholes Model • Assumption of the Model • There is no arbitrage opportunity (i.e., there is no way to make a riskless profit). • It is possible to borrow and lend cash at a known constant risk-free interest rate. • It is possible to buy and sell any amount, even fractional, of stock (this includes short selling). • The above transactions do not incur any fees or costs . • The stock price follows a geometric Brownian motionwith constant drift and volatility. • The underlying security does not pay a divident.

Black-Scoles Model

Empirical Analysis • Data source

Conclusion and Recommendations • The above analysis shows that, it is prudent andfinancially beneficial for the government of Nigeria togo into hedging using short maturity options. Hedgingstabilizes the fluctuations of company’s cash flows. • Hedging decreases company’s price risk exposurewhen being involved with physical products

Conclusion and Recommendations • It also provides effective financial management of thecompany and enables management to focus on other factors of the business. • Also, options are more flexible compared to other derivative instrumentsused in price risk management

Conclusion and Recommendations • Short maturity options are cheaper and with less risk as comparedto long maturity options and hedging with optionssecure competitive advantage by locking in high/low prices.

OPTION PRICING OF CRUDE OIL: AN APPLICATION OF BLACK-SCHOLES MODEL