AMERICAN JOURNAL OF SOCIAL AND MANAGEMENT SCIENCES

ISSN Print: 2156-1540, ISSN Online: 2151-1559 doi:10.5251/ajsms.2010.1.1.67.74

© 2010, ScienceHuβ, http://www.scihub.org/AJSMS

Application of options in hedging of crude oil price risk

Dontwi, I. K., Dedu, V.K. and Davis, R.
Department of Mathematics,
Kwame Nkrumah University of Science and Technology, Kumasi-Ghana
ABSTRACT
This study shows how options can be used for hedging crude oil price risk in accordance with
broad-based hedging strategies. Furthermore, it demonstrates how options are priced using the
Black-Scholes model and the benefits of hedging via options. The potential losses and gains
anticipated through hedging are illustrated using the scenario in the context of the current oil finds
in commercial quantities in Ghana.
Keywords: Hedging, Black-Scholes model, volatility, risk, options.

INTRODUCTION Everything in the contract is negotiable: the quantity,

Governments have explored the possibilities of
hedging crude oil price as part of its measures to
minimize the impact of the risk of exposure to
international crude oil prices on the economy.
Hedging is the process in which an organization with
energy price risk will take a position in a derivative
instrument that gives an equal and opposite financial
exposure to the underlying physical position to
protect against major price changes.
Derivative transaction is a bilateral contract whose
value is derived from the value of some underlying
assets. There are Exchange traded derivatives and
Over-the-counter (OTC) derivatives, executable
through four derivative instruments that include
Forwards, Futures, Swaps and Options
Options: Options are different from other trading
instruments because they give the option holders the
right, but not the obligation, to buy (or sell) an
underlying asset at a specified price during an agreed
period of time. As a result, an option contract will only
be exercised if the market moves in favor of the
holder. They are more flexible than forwards or
futures, which can only be used to take a long or
short positions (Cherry, 2007).
Energy options are currently traded both on the
regulated futures exchanges and on the unregulated
OTC market. Exchange traded energy options are
based on futures contracts and are standardized
contracts. The settlement terms are fixed, the expiry
dates are fixed, and only a limited range of strike
prices are quoted at any point in time (Natenberg,
1994). OTC options are more flexible as they can be
tailored to meet any set of specifications required.
type, delivery or settlement procedure of the
underlying asset, the expiry date, and the strike price
for the contract (Long, 2000).
Specifications of Option Contracts
Hull (2006) defines option as the right to buy or sell
an asset. Options work like insurance. According to
Natenberg (1994), they provide the buyer (or option
holder) with protection against the adverse effects of
unpredictable future price movements in exchange
for a fixed payment (or premium) that is paid in
advance to the seller (or option writer).
There are two basic types of option contract: Call
options, which give the holder the right to buy and
Put options, which give the holder the right to sell
(McDonald, 2006).
The buyer of a call option pays a premium to the
seller and, in return, has the right (but not obligated)
to buy a specific amount and type of oil at a fixed
price, before or at a given date. The buyer of a put
option pays a premium to the seller and, in return,
has the right (but not obligated) to sell a specific
amount and type of oil at a fixed price, before or at a
given date. The fixed pre-determined price at which
the holder of the option can buy or sell the underlying
asset is usually known as the strike price or exercise
price. The date agreed in the contracts is usually
known as the expiration date, exercise date or the
maturity of the option.
There are two basic methods of exercising options:
the American options, which can be exercised at
any time up to the expiry date, the European
options, which can only be exercised on the expiry
date. Exchange traded options are all American,

while OTC options can be of either type. Some option
writers prefer to sell European options as this allows
them to plan their exposure more accurately. We will
be dealing with European options in this paper.
Option Trading Positions: There are four basic
option trading positions, each of which has its own
characteristic profile of risk and reward. The first is to
buy a call. That is, purchase an option to buy the
underlying commodity or asset.
The payoff is the value of the contract to one of the
parties on a particular date. Using the usual notation
in the financial literature, if K is the strike price and ST
is the spot price at expiration, then
Payoff on a purchased call= max[0, ST-K]. This is
shown in Figure 2.1 below.
Payoff
0
K ST
Fig 2.1: Payoff graph on a purchased call.
The second is to buy a put. That is, purchase an
option to sell the underlying commodity or asset.
Payoff on a purchased put= max[0, K-ST]. This is
shown in Figure 2.2 below.
Payoff
K the position and it’s negative when premium is
0 Volatility : Volatility is the most important factor in
K ST
Fig 2.2: Payoff graph on a purchased put
The third is to sell a call. That is write a contract that
gives the purchaser the option to buy the underlying
commodity or asset.
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Am. J. Soc. Mgmt. Sci., 2010, 1(1): 67-74
Payoff on a written call= -max[0, ST-K]. This is shown
in Figure 2.3 below.
Payoff
0
K ST
Fig 2.3: Payoff graph on a written call
The fourth is to sell a put. That is, write a contract
that gives the purchaser the option to sell the
underlying commodity or asset.
Payoff on a written put= -max[0, K-ST]. This is shown
in Figure 2.4 below.
Payoff
0
K ST
-K
Fig 2.4: Payoff graph on a written put
The profit on a position= payoff on position-future
value of net cost on position.
Cost is positive when premium is paid in attaining
received. Therefore, net cost can be positive or
negative.
option pricing. It measures the likely magnitude of
price changes over a given period, and is expressed
as a percentage of the underlying market price.
Volatility is calculated as the annualized standard
deviation of the distribution of percentage changes in
daily prices, which is assumed to be a normal
distribution. The time value of an option increases

with the volatility of the market. If volatility is expected
to be low, the future trading range will be narrower
and the present value of the potential income stream
from holding an option will be smaller since there is a
lower probability of a large change in prices before
expiry. However, if volatility is expected to be high,
the future trading range will be wider and the present
value of the potential income stream from holding an
option will be larger since there is a higher probability
of a large change in prices before expiry (Natenberg,
1994).
There are two types of price volatility used in pricing
options. These are the Historical volatility and the
Implied volatility.
Historical volatility – as its name suggests – is the
range that prices have traded in over a given period
in the past. Historical volatility allows us to see how
prices have behaved under known market conditions.
From this, we may be able to build a confidence level
to help us in assessing the predictability of current
situations. Volatility is defined in terms of variations in
the proportionate change in price. Therefore, when
finding an estimated value of it, we must take the
standard deviation of ln(St/St-1). We observe these
ratios daily, weekly or monthly and obtain an estimate
of daily, weekly or monthly volatility. Then we multiply
this by the square root of 365 over the unit (that is,
365 for days, 52 for weeks, 12 for months) to obtain
the annual volatility (Weishaus, 2008).
Choosing an appropriate number of data to be used
in the volatility estimation is not easy. More data
generally lead to more accuracy, but volatility does
change over time and data that are too old may not
be relevant for predicting the future volatility. An
often-used rule of thumb is to set the number of data
equal to the number of days to which the volatility is
to be applied. Thus, if the volatility estimate is to be
used to value a 1-year option, data for the last year is
used (Hull, 2006).
Implied volatility is the range that prices are expected
to trade over a given period in the future. Implied
values are calculated by inputting option premiums
into an option pricing model.
Black-Scholes Pricing Model: In financial terms,
the price of an option is simply the present value of
the future income stream that can be expected from
holding the option contract (Fusaro, 1998).
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Am. J. Soc. Mgmt. Sci., 2010, 1(1): 67-74
In the early 1970’s, Fischer Black, Myron Scholes
and Robert Merton made a major breakthrough in the
pricing of stock options. This involved the
development of what has become known as the
Black-Scholes model. The model has had a huge
influence on the way that traders price and hedge
options.
Assumptions
The Black-Scholes model is based on a few
simplifying assumptions.
1. Stocks pay no dividends during the life of the
option.
2. The Black-Scholes model only prices European
call options.
3. No commissions are charged.
4. Interest rates and volatility remain constant and
known.
5. Stock prices are lognormally distributed.
6. Markets are efficient.
7. Shares of a stock can be divided.
Brownian Motion
The Black-Scholes formula is a closed-form formula
for evaluating the value of a European option. This
pricing is based on the assumption that the
movement of asset prices follows some sort of
random walk. A (one-dimensional) discrete random
walk models somebody starting out on the x-axis at
the point 0 and then moving left or right at the rate of
1 per unit time, with the direction being chosen
randomly. Suppose that instead of moving 1 per unit
of time, we moved h per h units of time and took
the limit as h → 0 . Then we would have a
continuous random walk which is a normal random
variable, and we would have Brownian motion. This
is also known as the Wiener process (Weishaus,
2008).
Brownian motion Z (t ) is a random process, a
collection of variables indexed by time t , defined by
the following properties:
1. Z (0) = 0
2. Z (t ) has a normal distribution with mean
0 and variance t .
3. Increments are independent
4. Z (t ) is continuous in t .
Brownian motion is a particular type of Markov
stochastic process. A Markov process is a stochastic
 Am. J. Soc. Mgmt. Sci., 2010, 1(1): 67-74

process where only the present value of a variable is
relevant for predicting the future. The third property of
the Brownian motion stated above implies that Z (t )
follows a Markov process.
Arithmetic Brownian motion (or the generalized
Weiner process) consists of a Brownian motion
scaled by multiplication and shifted by addition. The
mean change per unit time for a stochastic process is
known as the drift rate and the variance per unit time
is known as the variance rate. If X (t ) is an
arithmetic Brownian motion (and note that Z (t ) is
Brownian motion), then
X ( t ) = α t + σ Z (t )
Thus, X (t + s ) − X (t ) has a normal distribution with
mean α s and variance σ 2 s .
α is the expected drift rate per unit of time and σ is
called the volatility of the process.
Arithmetic Brownian motion is not a good model for
stock price movement because, it can go negative
and does not scale with stock price; one would
expect the proportional movement of stock price,
rather than the arithmetic movement, to follow a
future time T is normally distributed, with mean
(α − 0.5σ 2 )T and variance σ 2T . That is,
ln ST − ln S 0 ~ N ⎡⎣ (α − 0.5σ 2 )T , σ 2T ⎤⎦
or
ln ST ~ N ⎡⎣ ln S 0 + (α − 0.5σ 2 )T , σ 2T ⎤⎦
Which shows that ST follows a lognormal
distribution.
In a risk-neutral world, α is replaced with the
continuous compound interest rate r .
The principle of risk-neutral valuation implies that the
present value of the option is the expected final value
of the option discounted at the risk-free interest rate.
Let us consider a call option, which is known to have
a final value of max( ST − K , 0) at time T . By the
risk-neutral principle, the premium, C paid for this
option at time 0 is
C = e− rT E[max( ST − K , 0)]
∞

constant distribution. Just like we transform a normal

= e− rT ∫ (ST − K ) f ( ST )dST
K
distribution to a lognormal distribution, we transform where f ( ST ) , the probability density function of
arithmetic Brownian motion to geometric Brownian
motion. ST (lognormal) can be explicitly written as
⎛ 1 ⎞
To calculate the distribution of a geometric Brownian
⎜ − [lnST −(lnS0 +(r −0.5σ2)T)]2
motion X (u ) , let t be the latest time for which you 1
f (ST ) = exp⎜ 2
have the value of X (t ) . Then ln X (t + s ), s > 0 , is σST 2πT ⎜ σ2T
normally distributed with mean ⎝ ⎠
ln X (t ) + (α − 0.5σ ) s and variance σ s . For a
2 2
⎛ 1 ⎞
⎜ − [lnST −(lnS0 +(r−0.5σ2)T)]2 ⎟
stock with annual continuous return α and annual ∞ 1
C=e−rT ∫ (ST −K) exp⎜ 2 ⎟dST
continuous dividend δ , the drift will be α − δ . σST 2πT ⎜ σ2T ⎟
K
The value at time t of a geometric Brownian motion ⎝ ⎠
with drift α and volatility σ can be expressed as
Solving this integral, we get

ln X (t ) = ln X (0) + (α − 0.5σ 2 )t + σ Z (t )
C = S 0 N ( d1 ) − Ke − rT N ( d 2 ) (4.2)
(4.1)
where
⎛S ⎞ ⎛ σ ⎞
2
The Black-Scholes Formula
ln ⎜ 0 ⎟ + ⎜ r + ⎟T
From equation (4.1), if ST and S 0 are the prices of ⎝K⎠ ⎝ 2 ⎠
d1 = , and
the underlying security at time T and 0 respectively, σ T
then
⎛S ⎞ ⎛ σ ⎞
2
ln ST = ln S0 + (α − 0.5σ 2 )T + σ Z ln ⎜ 0 ⎟ + ⎜ r − ⎟T
⎝K⎠ ⎝ 2 ⎠
In fact, it can be easily seen from the above equation d2 = = d1 − σ T
that, the change in ln S between time 0 and some σ T

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N ( x ) is the cumulative distribution for the standard

normal distribution. In other contexts, N ( x ) is known
as Φ(x).
Equation (4.2) is the Black-Scholes formula for a call
option on non-dividend stock.

The corresponding price for a put option on non-

dividend stock is given by,

P = Ke − rT N (− d ) − S N (− d )
The general form of2 the Black-Scholes
0 1 formula for a
call option is
Fig 5.1: Crude oil prices
C = F P ( S ) N ( d1 ) − F P ( K ) N ( d 2 )
where Hedging with Options: Options can be used to
1 achieve a great variety of possible outcomes
ln( F ( S ) / F ( K )) + σ 2T
P P
depending on the exposure and risk preferences of
d1 = 2 and the user. The next two sections describe common
σ T option trading strategies that are widely used in the
oil industry.
1
ln( F P ( S ) / F P ( K )) − σ 2T Producer Hedge: An oil producer or distributor
d2 = 2 = d1 − σ T would like to hedge the value of its production. On
σ T October 9, 2009 (the day that the data was analyzed)
In this equation, F
P
indicate a pre-paid forward the price of crude oil is $x/barrel. The producer
price (present value of forward price). expects prices to fluctuate during the two years
S is the underlying asset-that is the asset which you period of the hedge (from October 9, 2009 – October
9, 20ll), but is concerned about the risk of prices
may elect to receive at the end of the period, T . K
falling below $y/barrel. If the producer is also
is the strike asset-which is the asset you may elect to
prepared to accept a maximum price of $z/barrel for
pay at the end of the period, T. its production, a combination of put and call options
can be used to hedge. Buy a $y/barrel put option and
Data Analysis: The study was limited to secondary sell a $z/barrel call option. The result of this strategy
data obtained from The Energy Information is to limit the downside and upside price risks to a
Administration on weekly all countries spot price of range between $y/barrel and $z/barrel.
crude oil from January 2006 to October 2009. The
Black-Scholes model is used for the computation of If prices of crude oil fall below $y/barrel at the end of
the options prices and some of the trading strategies two years, the $z call option will be worthless but the
of the options used in hedging commodities like $y put option will be exercised giving the producer
crude oil are looked at. the right to sell its output at $y/barrel, however low
prices go. If prices rise above $z/barrel, the $y put
Figure 5.1 shows the fluctuations in crude oil prices option will be worthless, the $z call option will be
over a period of two years (October 2007-October exercised and the producer will be obliged to sell
2009). crude at $z/barrel, however high prices go. If prices
are between $y/barrel and $z/barrel, neither of the
options will be exercised and the producer sells its
crude at the prevailing market price. This strategy is
known as a collar. The strike price of the option can
be set at any level, but the put and call options must
be equally far out-of-the money if the cost of the put
and call is to be the same. If the costs of the options
are the same, the strategy is known as a zero cost
collar (Cherry, 2007).

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Consumer Hedge: A crude oil consumer has based
its crude oil purchasing plan on a maximum price of
$x/barrel in two years time. In order to protect
themselves against a price move above $x/barrel, the
purchasing department could buy a two years $x call
option. The result of this strategy is to limit the upside
price risk so that the maximum price paid by the
company for crude oil would be $x/barrel (Hull, 2006).
If prices rise above $x/barrel at the end of two years,
the call option will be exercised and the company can
obtain its supplies from the option writer at $x/barrel.
However, if prices remain below $x/barrel, the $x call
option will not be exercised and the purchasing
department can meet its plan target with direct
purchases on the spot market. However, the
purchasing department will lose the premium paid at
the beginning of the transaction (at time 0) for the call
option. The combined profit on the crude oil and
purchased call will then be equal to the profit on the
purchased call.
The values as shown in Table 1 and Table 2 indicate
the profit that would have been realized if a consumer
(or Ghana Government) had hedged crude oil prices
in 2007 and 2008 respectively. The spot price for
each month is the monthly average crude oil price
(dollars per barrel) and the volatility is estimated from
crude oil prices in the previous year. For the year
2007, the Volatility=0.1915 and for the year 2008, the
Volatility=0.2222.
The expiration time is six months (T=0.5) and the
strike price is the forward price of the monthly spot
price (K=S0erT). In fact, these derivative traders
usually use LIBOR (London Interbank Offer Rate) as
short-term risk-free rates. This is because they
regard LIBOR as their opportunity cost of capital. For
the year 2007, Interest rate=0.0528 and for the year
2008, Interest rate=0.0317.

Table 1: Hedging in 2007

Date S0 K N(d1) N(d2) C CerT ST Payoff Profit

Jan-07 50.7725 52.1307 0.527 0.473 2.7407 2.814 72.8675 20.7368 17.9227

Feb-07 53.65 55.0852 0.527 0.473 2.896 2.9735 69.478 14.3928 11.4193

Mar-07 58.698 60.2683 0.527 0.473 3.1685 3.2533 73.8825 13.6142 10.361

Apr-07 63.6725 65.3758 0.527 0.473 3.437 3.529 78.155 12.7792 9.25018

May-07 63.905 65.6146 0.527 0.473 3.4496 3.5419 88.862 23.2474 19.7056

Jun-07 66.894 68.6835 0.527 0.473 3.6109 3.7075 87.62 18.9365 15.229

Jul-07 72.8675 74.8168 0.527 0.473 3.9334 4.0386 89.865 15.0482 11.0096

Aug-07 69.478 71.3366 0.527 0.473 3.7504 3.8507 90.816 19.4794 15.6286

Sep-07 73.8825 75.859 0.527 0.473 3.9882 4.0949 100.48 24.621 20.5262

Oct-07 78.155 80.2458 0.527 0.473 4.2188 4.3317 104.98 24.7342 20.4026

Nov-07 88.862 91.2392 0.527 0.473 4.7968 4.9251 118.928 27.6888 22.7637

Dec-07 87.62 89.964 0.527 0.473 4.7297 4.8562 128.063 38.0985 33.2423

Total profit=$207.4606

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Table 2: Hedging in 2008

Date S0 K N(d1) N(d2) C CerT ST Payoff Profit

Jan-08 89.865 91.3007 0.5313 0.4687 5.6271 5.717 133.5225 42.2218 36.5048

Feb-08 90.816 92.2669 0.5313 0.4687 5.6866 5.7775 113.972 21.7051 15.9276

Mar-08 100.48 102.085 0.5313 0.4687 6.2918 6.3923 98.515 0 -6.3923

Apr-08 104.98 106.657 0.5313 0.4687 6.5735 6.6786 73.952 0 -6.6786

May-08 118.928 120.828 0.5313 0.4687 7.4469 7.5659 50.9025 0 -7.5659

Jun-08 128.0625 130.108 0.5313 0.4687 8.0189 8.147 39.7075 0 -8.147

Jul-08 133.5225 135.656 0.5313 0.4687 8.3608 8.4944 40.358 0 -8.4944

Aug-08 113.972 115.793 0.5313 0.4687 7.1366 7.2506 41.225 0 -7.2506

Sep-08 98.515 100.089 0.5313 0.4687 6.1687 6.2673 45.19 0 -6.2673

Oct-08 73.952 75.1335 0.5313 0.4687 4.6307 4.7046 49.355 0 -4.7046

Nov-08 50.9025 51.7157 0.5313 0.4687 3.1874 3.2383 54.914 3.19827 -0.04

Dec-08 39.7075 40.3419 0.5313 0.4687 2.4864 2.5261 67.6975 27.3556 24.8295

Total profit=$21.72133
price for the purchase or sale of oil at a future date in
The total gain and total loss for 2007 and 2008 are exchange for a fixed non-refundable “insurance”
illustrated in Figure 5.2 below. premium. When options are used in hedging, the
losses are limited to the premium paid.

The Black-Scholes model is used for pricing

European options and some of the factors that affect
the price of options are the current stock price, the
strike price, the time to expiration, risk-free rate and
the volatility. Currently, the price of crude oil has
become very volatile with an estimated annual
volatility of 42.69%. From Table 1, no losses were
observed in the year 2007 as a result of hedging and
even though some losses were recorded in the year
2008 (from Table 2), the profit recorded was positive.

Standard deviation is the measure of dispersion of a

Fig 5.2: Graph of total gain and total loss
Analysis and Discussion of results: Options
enable companies to lock in a maximum or minimum
set of data from its mean and according to the Black-
Scholes model, stock prices have standard deviation
of σ T .
This means that, for time greater than one, the
standard deviation or the uncertainty about the future
price of a stock increases with time. Also, money
depreciates with time and so options with longer
maturities loose their value with time.

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CONCLUSIONS:
The above analysis shows that, it is prudent and
financially beneficial for the government of Ghana to
go into hedging using short maturity options. Hedging
stabilizes the fluctuations of company’s cash flows.
Hedging decreases company’s price risk exposure
when being involved with physical products. It also
provides effective financial management of the
company and enables management to focus on other
factors of the business. Also, options are more
flexible compared to other derivative instruments
used in price risk management. Short maturity
options are cheaper and with less risk as compared
to long maturity options and hedging with options
secure competitive advantage by locking in high/low
prices.
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