One of the most important operating expenses for the Olde Virginia Brick Company is natural gas, which is used to bake and dry the bricks. Natural gas prices have recently been quite volatile, now approaching $6 per mcf. Olde Virginia is bidding on a contract for a large quantity of bricks to be provided for a new mall project that is under construction. The bricks must be delivered in 6 months. Olde Virginia has estimated that it can make a nice profit on the order at the current price of natural gas. If natural gas prices increase to $6.50 per mcf, Olde Virginia will just break even on the order. The 6 month futures contract price for natural gas is $5.75 per mcf. The cost of a call option to buy natural gas at $5.75 is $0.20 per mcf.
a. If Olde Virginia does not hedge the cost of its natural gas inputs, what is the expected cost of the gas to produce this large order?
b. If Olde Virginia hedges the cost of its natural gas inputs in the futures marke,t what is the expected cost of the gas for this order?
c. If Olde Virginia hedges the cost of its natural gas inputs by buying call options at a strike price of $5.75, what is the expected cost of the gas for this order?
d. Which strategy would you suggest and why?