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 market, 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?

In case the company does not hedge the cost of the gas, then at current market levels, it would have to pay $6 per mcf for purchase of the gas. However, there is a risk of increase in the price of the gas to $6.50 which would lead to break even situation for the company.

If the company hedges the cost of gas through a Futures contract, then the cost of the gas would be $5.75 per mcf.

If the company hedges the cost of gas through an Options contract, then the cost of the gas would be $5.75 per mcf plus, the company would be required to pay $0.20 per mcf to buy the Option, and in effect, the cost per mcf would be $5.95 per mcf.

The appropriate strategy would be to buy a futures contract, because the cost per mcf in this case would be least.

***These answers are from another user.. But I don't understand the problem or how to get to the solution