ABC corporation has just signed a contract to buy agricultural equipment from XYZ corporation, a German firm, for 1,250,000. The purchase was made in June with payment due six months later in December. Because this is a sizable contract for the firm and because the contract is in pounds rather than dollars, Plains States is considering several hedging alternatives to reduce the exchange rate risk arising from the purchase. To help the firm make a hedging decision you have gathered the following information.

The spot exchange rate is $1.40/

The six month forward rate is $1.38/

Plains States' cost of capital is 11% p.a.(or 5.5% for 6 months)

The borrowing interest rate is 9% p.a.(or 4.5% for 6 months)

The lending interest rate is 7% p.a.(or 3.5% for 6 months)

The U.S. borrowing interest rate is 8% p.a. (or 4% for 6 months)

The U.S. lending interest rate is 6% p.a. (or 3% for 6 months)

December CALL options for : size of ONE contract, 625,000; strike price $1.37, premium price is 1.5%. Use current Spot exchange rate, not strike price to calculate premium.

Plains States' forecast for 6-month spot rates is $1.38/

The budget rate, or the highest acceptable purchase price for the equipment, is $1,750,000 or $1.4/

You are required to furnish a recommendation as to whether the firm should:

Q1) Remain Unhedged

Q2) Hedge with Forward

Q3) Set up a Money Market hedge

Q4) Hedge with option

Q5) Make sure you show potential payoffs attributable to each alternative described above and support your recommendation in detail.