37 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:

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

a0 = 0:0 a1 = 1:1 a2 = 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:

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

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where: e=ao+aDINF-1 + aDINT, +& DINF:-1 DINT percentage change in British pound value over period t differential in inflation between the United States and the United Kingdom in period t - 1 = average differential between US interest rate and British interest rate over period t ao, a, and a2 = E = regression coefficients error term.