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.