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Logic of Hedging: Sam Crawford at Morrison Oil Company

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Morrison Oil Company's chief financial analyst is Samuel Crawford. Sam completed his analysis suggesting that the investment was indeed a good one for the company and presented it to the firm's executive committee. The executive committee consists of the firm's CEO, CFO, and COO. The CFO thought Sam's analysis was on target, but the COO and CEO were concerned about the fact that the hedging strategy would not work for the investment. In fact, they wondered why hedging the investment was such a good idea. Sam thought for a second or two before responding and decided how to best explain why the project was a good one and involved hedging the investment cash flows using one-year call options on natural gas. These call option, which have a $13.90 per MCF strike price, were selling for $1.86 per MCF. Show how selling call option on 50 MCF of gas today and undertaking the investment provides Morrison with a hedged (i.e., risk free) investment.

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Solution Summary

The logic of hedging for Sam Crawford at Morrison Oil Company is examined.