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 recieve 2 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 $.03 per unit. Your forecast of the percentage change in the spot rate

was determined from the following regression model:

E t = a 0 +a 1 DINF t-1 +a 2 DINT t +

The regression model was applied to historical annual data, and the regression coefficients were

estimated as follows:

a 0 = 0.1

a 1 = 1.2

a 2 = 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 (DINT t ) is forecasted as follows for this year:

Forecast of DINT t Probability

1.5% 30%

2% 40%

3% 30%

Using any of the available information, should the treasurer choose the forward hedge or the put

option hedge?