Mr. A.T. risk owns a food processing business, A.T. Risk Enterprises Inc. At Risk needs 1,000 tons of flour in three months time (June). At Risk is worried that the price of flour may increase and wants to hedge against price increases of flour. Mr A.T. Risk can not locate a forward contract, futures contract or option for flour. Thus he decides to enter an options contract to buy 25,000 bushels of wheat. Further he finds out the following:
- at current spot prices, the total value of the flour inventory is $350,000; if the option is excercised at the strike price 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
- delivery locations for wheat and flour differ
Will the hedge be highly effective or not?