China Aviation Oil Case Study Solution
China Aviation Oil (Singapore) Corporation Limited
Derivates also knew as an option. It is a form of a contract or actual contract which gives the right to one party but not an obligation which allows one party to perform any specific task with one party. Options can be utilized in many types of contracts. Companies are linked to many underlying assets. Most exchange-traded options on stock consider their underlying assets but OTC-options can deal with a huge variety of assets examples are bonds, currencies, swaps or commodities. Options are very important accounting tool used to generate profit for a short run but manage all related risks with options. Generally, options have two more types:1) call option 2) put option
- Call option: in a call option, the holder has right to buy any underlying assets at specified price or strike price. But only for a certain period of time. But before the expiry date if the stock cannot meet the specified date the options going to dismiss and stock becomes Investors use call options for shares normally when the market trend shows that their prices will rise in future and they sold the shares when you get the rumor of going the prices at a low level. Selling of call options also known as writing the option. A call is a contract of option that used buyer to purchase the low prices assets. The expiry of options varies and may fluctuate between short or long-term expires. It is only beneficial for the call buyer to utilize the options if the current price is going to increase by strike price. For a set amount of time, call buyer can buy stock. If the price increases by strike price the option will have intrinsic value. And at that point when a trader sells stock, he gets profit or exercises the option before expiry. Premium has to pay by call buyer for these rights. The call writer receives the premium when exercising the options. Writing call options is a format which we generate the money for the business. Writers receive a limited amount of premium but call sellers receive an unlimited amount of profit. Call prices are normally related to per share. Call options can be in money or out of money according to requirement. In the money means the strike price is below from underlying assets. Out of money means strike price is above that strike price. While using call option, you can use money or out of money or at money. At money means both underlying prices and strike prices are same. In case of in the money premium will be higher and in case of out of money premium will be lower.
- Put Option: input option, the holder has right to sell an underlying asset at a strike price. Input option, it is the obligation of the seller to buy all stock at a fixed price or specified price. This option can be exercised before the date of expiry. Investors buy the stock using put option when market trends show that the price of underlying stock will going to reduce or sold the stock when the prices of underlying stock will going to high. Long holding put buyer are those buyers who may work as insurance buyer to secure their long positions in a stock or speculative buyers who are looking for leverage for the period of time which utilize options. As an expectation of market to go upward, put seller holds for a short period. Downward market turn is the worse condition for the put The profit is limited as the amount of premium is consider as profit and it only receive when the underlying prices go above the option’s strike price before the date of expiry. The loss is unlimited which has to face the put seller. Buyer has to pay an option premium to exercise this right. This amount is payable at the time of options is started for obtaining the right. Premium is also paid at this time. It’s a contract that provides right to sell the underlying assets at a specified price before expiry. For put buyers it’s only beneficial when option exercise and force the seller to sell at a specified price only when the strike price is greater than underlying price. For a set amount of time, put buyer can sell all stock at a specified price. The option will be worth full if the number of underlying moves below to strike price. A seller can exercise the option at the date of expiry or sell the option of earning a profit. Put buyer pays the amount of premium to attain these rights. Writers of put option receive the amount of premium. Input option, writing is a way to make income. The amount of premium which a put writer receive is limited in quantity but can earn an unlimited amount of money when the price of the stock going to be zero. Put prices are measure according to per share amount. Put option can be in the money, at the money or out of money. In money put specified price is greater than underlying prices, and out of money means strike price is less than underlying price and at the money means that strike price and underlying prices are same. Any option can be selected while choosing an option. Amount of premium increase when you use the money and premium is going decrease when you select out of money.
The pricing of options is very complicated because the premium includes many factors like the volatility of underlying assets, in or out of money options and expiry duration of stock. These inputs are known as Greeks and having to worth before selecting options.
An IAS 39 financial instrument creates principles of recognizing and calculates financial assets, some contracts to sell or purchase non-financial assets and financial liabilities. It also mentions rules for derecognizing financial instruments and for hedge accounting. The disclosure and presentation are the subjects of IFRS 7 and IAS 32 of financial instruments.
In a financial statement, financial instruments can be recognized when in the financial instrument contract an entity becomes a party. When the obligation is expired, the financial liability will be removed from financial statements. When entity removes from the financial statements, the financial assets when the right of asset cash flow is finished or when asset transfer including all risks and rewards, when ownership transfer only but the current part has to face all risks and rewards . in simple, the retention of risk and reward recognized an asset. Financial liabilities or financial assets may be measured at fair value, sometime amortize cots also used but the fairest value will be used. The following financial liabilities or assets show that who measure at fair value and who at amortize costs. 1) measure at amortizing cost: loans and receivables, financial liabilities that not carried at fair value, and held to maturity investment,2) measured at fair value: financial assets and liabilities for trading, and available for sale financial assets.
Now we move to the discussion of Cao.
China aviation oil corporation Ltd is a subsidiary of China national aviation fuel group by having 51% of shares in CAO. It is trading in jet fuel and considered as most well known and well-reputed organization of Singapore .the main business of Cao is to supply fuel, trading of other oil products and investment in oil-related assets, In 1993 Cao has top of the list in Singapore exchange security commission. BP is the strong strategic investor who holds 20% of shares in CAO.
At the end of third quarter 2003, it starts trading by call options. They want to increase the price of their share and also want to increase the profit of the company. When the prices of oil increase, company has earned a large amount of profit. The company uses this method without the permission of directors and without managing the risks related to those prices. This strategy will work also in the fourth quarter but after this, the price of oil going to decrease speedily and in 2005 company has to suffer 550 million losses. Now, what should a company do to overcome these losses and again make its good reputation in the market!
First of all, the managing persons of CAO discuss all problems with its parent company. Told them all the methods they used to generate money. Give detail knowledge to directors of CAO and discuss with them this matter. Focus the reasons behind the losses. CAO face 550 million amount of loss because they consider the price of shares according to their fixed price but unfortunately, the prices fell incoming time period and instead of gaining profit they have to suffer loss, not only this company continue with the options strategy and the number of losses increase as before. CAO has to stop utilizing the options because before we cannot manage its risk which causes too many losses in future. We stop call and put option on our share price .no doubt we can generate money in the short time period but it has some worse disadvantages. So all trading of shares with counter enterprises will be finished or removed. And a proper risk management committee should be developed who handle all such type of conditions. CAO has to implement IAS 39 financial recognition standard in their books of accounts which is helpful in identify all the financial instruments included in the company and used or recorded properly in the statements of accounts which declare that all used instruments are legal and company used IAS rules instead of company itself rules which causes loss of company. The company has to take time because the amount of loss is too big that its adjustment is not easy. The company has to again offer shares with reasonable prices and offer a legal time span which follows all rules and regulations of accounting standards. After some years, the company again achieves the previous achievements and its reputation in the market, in Singapore where this company captures the big share of the market.
Basically, derivates are the estimation of market trends and demand of market which affect the progress of companies on both sides. Special managing team and decision makers have to appoint in companies which handle all such problems and try not to disturb our profit and market reputation. Another point is that the prices of oil or fuel always goes upward as from many years we have studied in the company and always give a reasonable profit to a company which helps to improve its position in the market. Although, the strong need of making such type of strategies in which legal and financial instruments should be utilized because the market is unpredictable. We only determine through past experience but we cannot give facts and figures regarding future condition of the market.
The CEO of the company also not focuses on the insufficiency of the market. He only attention on completing the call and put options as their expiry date arrived but this will suffer our great loss of 550 million, also destroy the reputation of the company.
Always use proper rules and regulations and for accounting point of view adopt international accounting standards for preparing their books of accounts and by following international rules, the company becomes more trustworthy in front of other companies and in customers.
China aviation oil corporations dealing in a very sensitive commodity which is oil and all oil-related products and oil-related assets. These commodities are very sensitive to prices and their market has no assurance to maintain the price in future. Price s of these commodities are differed because of different economy changes, political changes in the country, climate changes, therefore, its price is unpredictable and company should concern all pros and cons before starting any dealing with any third party. Another important thing is that they should be done fair dealing with their customers and clients. Because clients’ satisfaction level is very much important and in this field good customer can give you good price rate and make your reputation at a good level in the markets. Its parent company China national aviation fuel group corporation supports its subsidiary to reveal from these crises. It provides better funding and helps to motivate and again come in the list of best companies in this industry. Its strategy investors also support and don’t let the company in crises. They fully support it and help to raise the share price of the company in the market. Corporations having unique commodities like oil, fuel should take new steps regarding the prices very carefully. Because big change can raise their profit but a big downfall can destroy the image and financial condition of the corporation.
Expect all the above discussion, it doesn’t mean that using options are always cause a loss of the business. In many businesses, call and put options use constantly these companies earn many incomes from exercise these options. But to some extent, it also depends on the commodity. High rated and sensitive commodities whose rate may drastically change will not deal in this regard. This call and put options are very useful but only for short time period. This would not be suitable for long-term stocks because prices will be change speedily and in long-term, they may not give the proper or sufficient amount of profit in future. The premium amount is also profit for the company but same as above for short period.
The crux of all above discussion shows that CAO is a high commodity dealing corporation and they should be careful about the price fluctuation of oil or fuel in future according to market demand and trend. Options are accounting instruments and used to generate income in a short period of time. CAO use to call and put option to generate money but in a few months later they have to face a drastic loss of 550 million which collapse the dealings of CAO in the market and their market image going to destroy. Its reputation going to finish in the market. Now they take precautionary measurements to again settle their business dealings with customers. Use proper accounting tools that legally have worth in the market. Be careful about the prices of oil and fuel regarding future. Options or derivatives are also very helped full tools of accounting which use to generate income for short period of time because the prices will not remain same in long terms. Two type of options used in companies; call option and put options. Basically, options not only related to purchase of underlying assets it also belongs to the selling of underlying assets according to strike prices. Which include in money, at money and out of money, this will help to increase the amount of profit and premium for seller and buyer in short period. IAS is the internationally renowned and most important and famous standards that are used in every multinational company. Now it’s become the rule for companies to follow proper accounting standards for record keeping and making statements. For the authenticity point of view, it is compulsory to follow up these standards for external auditing because each and every entity record should be kept and safe by following some rules and regulations. The company also follow its rules and regulations built for accounting and calculating profit, we have to adopt these rules or standards which shows the accuracy and true data entering from all aspects of the company.
- (Options: Calls and Puts By Investopedia, 2018, Investopedia, LLC.)
- (Descriptions of call and put options) (BY ADAM MILTON Updated February 15, 2017)
- (IAS 39 Financial Instruments: Recognition and Measurement, IFRS Foundation 2017)