Plains States Manufacturing has just signed a contract to sell agricultural equipment to Boschin, a German firm, for euro 1,250,000. The sale 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 euros rather than dollars, Plains States is considering several hedging alternatives to reduce the exchange rate risk arising from the sale. To help the firm make a hedging decision you have gathered the following information.

The spot exchange rate is $1.40/euro

The six month forward rate is $1.38/euro

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

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

The Euro 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 put options for euro: size of a contract euro 625,000; strike price $1.38, 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 $1.43/euro

The budget rate, or the lowest acceptable sales price for this project, is $1,700,000 or $1.36/euro

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

Q1) Hedge with option

Q2) Make sure you show potential payoffs attributable to each alternative described above and support your recommendation in detail.