Should treasurer choose forward hedge or put option hedge

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Reference no: EM13935832

Hedging with forward versus option contracts. As treasurer of Temple plc you are confronted with the following problem. Assume the one-year forward rate of the US dollar is £0.62. You plan to receive $1 million in one year. A one-year put option is available. It has an exercise price of £0.63. The spot rate as of today is £0.63 and the option premium is £0.03 per unit. Your forecast of the percentage change in the spot rate was determined from the following regression model:

et ¼ a0 þ a1DINFt-1 þ a1DINTt þ e

where:

et ¼ percentage change in British pound value over period t

DINFt-1 ¼ differential in inflation between the

United States and the United Kingdom in period t - 1

DINTt ¼ average differential between US interest rate and British interest rate over period t a0, a1, and a2 ¼ regression coefficients

e ¼ error term.

The regression model was applied to historical annual data, and the regression coefficients were estimated as follows:

a0 ¼ 0:0

a1 ¼ 1:1

a2 ¼ 0:6

Assume last year's inflation rates were 3% for the United States and 8% for the United Kingdom. Also assume that the interest rate differential (DINTt) is forecasted as follows for this year:

Forecast of DINTt	Probability
1%	40%
2	50
3	10

Using any of the available information, should the treasurer choose the forward hedge or the put option hedge? Show your workings.

Reference no: EM13935832

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