Mel is a risk-neutral investor concerned about the future availability of gas. He is considering purchasing a gallon of gas today and placing it in storage for 10 years as a hedge against future gas price increases.
a. If today's price of gas is $4.00 per gallon, and the future price of gas is $6.00 per gallon, is placing a gallon of gas in storage a good idea? Assume that the market interest rate is 4%.
b. Suppose that Mel is uncertain of the future price of gas. He estimates that there is a 0.1 probability that gas will continue to sell for $4.00 per gallon, a 0.4 probability that gas will sell for $5 per gallon, and a 0.5 probability that gas will sell for $6.80 per gallon. Should Mel place a gallon of gas in storage today? Will your answer be the same if Mel is risk-averse?