npsE10B.tmp - Homework Assignment #7: Energy Economics 324...

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Homework Assignment #7: Energy Economics 324 Due Monday, May 3 1. Southwest Airlines typically uses the equivalent of 3.5 million barrels of crude oil per month in its flight operations. As of 4/20/10, crude oil was selling for $82.98 barrel for delivery at anytime from now through May. Use the tables on the last page to answer the following questions. a. What will it cost Southwest to purchase its entire fuel needs for May, June, July, and August at the current spot price? b. What will it cost Southwest to purchase its entire fuel needs for May, June, July, and August at the current respective futures prices? c. Why would Southwest be willing to pay more for oil in the futures markets rather than simply purchasing oil on the spot market? d. Based on observed futures prices for crude oil, do traders expect oil prices to rise or fall over the next 6 months? Now let’s just look at your demand for oil in August. Suppose that you do not buy a forward contract but are still planning on purchasing 3.5 million barrels of oil in August, and you want to guarantee that you will not pay more than a certain amount for this oil. You want the option to buy this oil at some maximum price, so you decide to buy a futures option. You buy an option that guarantees you the right to buy the entire shipment at a price of $90 per barrel. e. How much does this options contract cost? You have purchased this contract, and now August arrives. Assume the price of oil has moved to $80/barrel. f. Will you exercise the option? g. How many dollars will you pay for the oil after accounting for the price of the options contract h. How many dollars would you have paid without the options contract? (Assuming you did not purchase a forward contract either.) i. What is your gain or loss on the purchase of the option? Now assume instead by August the price of oil has moved to $100/barrel. j. Will you exercise the option? k. How many dollars will you pay for the oil after accounting for the price of the options contract? l. How many dollars would you have paid without the options contract? (Assuming you did not purchase a forward contract either.) m. What is your gain or loss on the purchase of the option? n. Based on your knowledge of oil prices over the past several years, do you suppose that oil options at a given spot price/strike price spread have generally increased or decreased in price over the past several years? Explain. o. Suppose that you also wished to purchase options to cover your fuel purchases in October. At a given strike price, would these options cost more or less than the ones you purchased for August? Why?
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Homework Assignment #7: Page 2 2. Subsidies generally lead to dead-weight because they cause people to consume more goods whose marginal costs exceed their marginal benefits to the consumers who use them. a.
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This note was uploaded on 05/04/2010 for the course EDUC 22331 taught by Professor Feev during the Spring '10 term at The School of the Art Institute of Chicago.

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npsE10B.tmp - Homework Assignment #7: Energy Economics 324...

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