Question

Your firm is leasing an offshore oil property with an estimated oil reserve of 50 million barrels of oil. It would take 2 years to fully develop the property and sell all of the oil on the market. The present value of the development cost is $12 per barrel. The firm has the rights to exploit this reserve for the next 20 years. The marginal value per barrel of oil is $12 per barrel currently. The 2‐year Treasury rate is 0.92%, the 20‐year Treasury rate is 2.58%, and the volatility of oil returns is 45%. What is the expiration date or maturity of the option? What is the strike price? Is this a call or put option? Which interest rate should you use in the option valuation formula?

Answer 1

The expiration date or maturity of the option is 20 years, with a strike price of $12 per barrel. This is a call option, with the 20-year Treasury rate used in the valuation formula.

Step-by-step explanation:

The expiration date or maturity of the option in this scenario would be 20 years, which is the period of time the firm has the rights to exploit the oil reserve. The strike price would be $12 per barrel, which is the present value of the development cost. The type of option in this case would be a call option, as the firm has the right to exploit the oil reserve. The interest rate that should be used in the option valuation formula is the 20-year Treasury rate, which is 2.58%.