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

You plan to receive 1 million pounds in 1 year. A oneyear 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 = percentage change in British pound value over period t DINFt−1 = differential in inflation between the United States and the United Kingdom in period t −1 DINTt = average differential between U.S.

interest rate and British interest rate over period t a0, a1, and a2 = regression coeffiecients

μ = 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:
Using any of the available information, should the treasurer choose the forward hedge or the put option hedge? Show your work.