We are Bechtel, a private US construction firm. We bid to develop the airport and the surrounding area for Thailand. We are not sure whether the Thai transportation authorities will grant us the business, but we hope they will. If we are awarded the contract, for which we bid $ 1 billion, we shall need to buy Thai materials and labor for 2 years. Assume that the purchases we need to make are half in one year and half the year, after the next one. The project will be completed in three years from the present. We expect the Thai bhat will revalue in the next 2 years. We have two choices. One is to hedge, paying the labor and materials in the next two years, and the other is to leave an open position.

The data we have are the following. The Spot ER, forward ER now, forward rate in one year and spot rate in one year are 24, 30, 28 and 27 bhat per $. The call and put option premia on bhat and dollars for exercise prices of 30 bhat per dollar and 25 bhat per $ are 2% and 1% of the value. The time period of the options is two years. Analyze what the best solution is. Show it 1) mathematically and 2) verbally.

Why may we perhaps not hedge?