Question

Discuss why the owner of an oil well might wish to buy put options for oil. As part of your discussion, briefly explain what is meant by put-call parity. Also explain how the Black-Scholes formula can be combined with put-call parity to estimate the market value of a European put option for oil. Note that you are not required to write down the Black-Scholes formula as part of the answer to this question.

Answer 1

Put option gives right to sell the underlying commodity at specified price, the owner has risk of price fall. To hedge such risk of price ,they buy put option for oil.

The put–call parity explains association of price of Put and Call option with the same strike price and expiry date ,

Price of Call (C) + PV ( Strike Price K) = Price of Put(P) + Spot Price(S) .

=> C-P= S - PV(K)

=> C-P = S - K e^-r(T-t)

The concept of Put-call parity holds true for European style of options only , which is based on the concept of no arbitrage . Which is used to derive the famous Black and Scholes formula of option valuation. and established a relation in spot price and value of option .

The strike price of oil in any eurpoean style option can be easily established by use of above model .