Mr. At Risk owns a food processing business, he needs 1,000 tons of flour in three months'

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Question:

Mr. At Risk owns a food processing business, he needs 1,000 tons of flour in three months' time. He is worried that the price of flour may increase and wants to hedge against price increases of flour. He can not locate a forward contract, future contract or option for flour. Mr. Risk decides to enter into an contract to buy 25,000 bushels of wheat. The option expires May 1, 2014. Further, Mr. Risk finds out the following:

*at current spot prices, the total value of the flour inventory is $350,000; if the option is exercised at the strike stipulated in the contract, the value of the wheat is $250,000

*the correlation between flour and wheat prices, traditionally is approximately 45%

*the option expires May 1, 2014

*delivery locations for wheat and flour differ