Hedging with Forward versus Option Contracts As treasurer of Tempe Corp., you are confronted with the following problem. Assume the 1-year forward rate of the British pound is $1.59.

You plan to receive 1 million pounds in 1 year.

A 1-year put option is available. It has an exercise price of $1.61. The spot rate as of today is $1.62, and the option premium is $.04 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 a2DINTt þ μ

where et ¼ percentage change in British pound value over period t DINFt−1 ¼ differential in inflation between the Untied States and the United Kingdom in period t1 DINTt ¼ average differential between U:S: interest rate and British interest rate over period t a0; a1; and a2 ¼ regression coeffiecients

μ 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 percent for the United States and 8 percent 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 work.