Hedging a commitment; forecasted transactionforward contract vs. option. Jackson, a U.S. company, acquires a variety of raw materials from foreign vendors with amounts payable in foreign currency (FC). The company needs to acquire 20,000 units of raw materials, and the goods are expected to have a price of 100,000 FC. Assume that the inventory can be subsequently sold to U.S. customers for $160,000.

Jackson is contemplating committing to the purchase of the inventory on September 1 with delivery on November 1. However, rather than making a commitment, the company could forecast a probable purchase of inventory with delivery on November 1. In either case, assume that on September 1 the company would either (a) acquire a forward contract to buy 100,000 FC with a forward date of November 1 or (b) acquire an option to buy FC in November at a strike price of $1.250. The option premium is expected to cost $2,100.

Various spot rates, forward rates, and option values are as follows:

1. Prepare a schedule that would compare the effect on current earnings of the two alternatives (commit or forecast), given the alternative hedging instruments. Show the effect on earnings for the period prior to the transaction date separately from the effect after the transaction date. The time value component of the hedging instruments is excluded from the assessment of hedge effectiveness. Changes in the value of the commitment are measured by changes in the spot rates.

2. Discuss your conclusion, and explain to Jackson why one alternative might be preferable over the other.

\begin{tabular}{lccr} & & Forward Rate for & TimeValueofOption \\ \hline September 1.. & 1FC=$1.250 & 1FC=$1.270 & $2,100 \\ November 1.. & 1FC=$1.320 & 1FC=$1.320 & 0 \end{tabular}