Financial Management of Risks 443Hedging with a Call Option
Consider the trucking company whose rates are regulated yet costs f luctuate
with market prices. The chief raw material purchased by the company is diesel
fuel. If fuel prices rise, the trucking company will suffer losses, and may in fact
be put out of business. As we saw above, the company can guarantee a fixed
price for fuel by going long in a future or for ward. Another strategy would be to
buy a diesel fuel call option contract. The strike price of the call option would
lock in the highestprice that the company will have to pay for fuel. If fuel
prices should drop below the strike price, the company would be under no
obligation to exercise the option. It would simply buy fuel at the low market
price. If, however, fuel prices rise above the strike price, the company would
exercise the option and buy fuel at the relatively low strike price.
The added f lexibility of the option over the futures strategy comes at a
cost. When the company buys the call option it must pay a price or “premium.”
The call option is essentially an oil price insurance contract for the firm, insur-
ing that fuel prices will not exceed the strike price. If fuel prices remain low,
below the strike price, the company will not collect on this insurance policy,
and the initial premiums will be lost.
Pricing Options
At this point the reader may wonder how the initial price of an option is deter-
mined. Option pricing is no trivial exercise, and a thorough treatment of option
pricing is beyond the scope of this chapter. Some basic principles, however,
can be explained here. First, an option’s “intrinsic value” prior to expiration is
equal to its payoff. That is, if an option is out of the money, its intrinsic value is
zero. If a call option is in the money, for example, if the strike price is $70 and
the current stock price is $80, then the intrinsic value equals the stock price
minus the strike price, $10.
The value of an option, however, exceeds its intrinsic value. An out-of-
the-money option is worth more than zero, and the in-the-money option de-
scribed above is worth more than $10. This extra value is due to the fact that
the downside losses are capped off, but the upside potential is unlimited. As
long as there is still time remaining in the option’s life, it is possible that an out-
of-the-money option can go in-the-money. An in-the-money option can go fur-
ther in the money, and has more upside potential than downside.
A call option’s value is a function of the underlying stock price, the strike
price, the amount of time remaining to expiration, the interest rate, the stock’s
dividend rate, and the volatility of the underlying asset price. As the underly-
ing stock price rises, so will the call option’s value. Holding the other variables
constant, a call option’s value will be greater when there is a higher stock price,
lower strike price, longer time to expiration, higher interest rate, lower divi-
dend rate, and more volatility in the underlying asset. Researchers have suc-
ceeded in formalizing an equation that prices options as a function of these