prob sol 12-1 - Conversely if volatility decreases, the...

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PROBLEM 12-1 Given Solution Legend Quantity 1000 = Value given in problem Price (Year 0) $20 = Formula/Calculation/Analysis required P-high $25 = Qualitative analysis or Short answer required P-low $15 = Goal Seek or Solver cell Forward price $20 = Crystal Ball Input Extraction costs $17 = Crystal Ball Output Solution Profit (sell today) $3,000 Cert. Equiv (sell forward) $3,000 Uncertain Profits Profit-high $8,000 Profit-low $(2,000) Risk neutral probability 0.5 Value of public land $4,000 Extract oil only in this state of the world Do not extract oil in this state of the world a. It is better to wait because the option to wait is valuable (4000 vs. 3000). b. If the volatility in oil prices increases, the option value should increase.
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Unformatted text preview: Conversely if volatility decreases, the option value decreases. P is the REALIZED price of 175 ounce of gold next year If the price of 175 ounces of gold goes above $106,000, Jim Lytle's strategy pays off more than the client's strategy. On the other hand if the price of 175 ounces of gold stays below $106,000, the client's strategy provides greater payoffs. You can lock into the forward rate or sell immediately at the same spot rate. The payoffs under either action is the same. Selling today is better because of time value of money. Equate forward price = expected cash flows based on risk neutral probabilities: 20 = 25 * p + 15 * (1 - p)....
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