Forward versus Option Hedge As treasurer of Tempe Corp., you are confronted with the following problem. Assume the one-year forward rate of the British pound is $1.59. You plan to receive 1 million pounds in one year. A one-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 $0.04 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 D I N F t − 1 + a 2 D I N T t + μ where: e t = percentage change in the value of the British pound over period t DINF t − 1 = differential in inflation between the United States and the United Kingdom in period t − 1 DINT t = average differential between the U.S.interest rate and the British interest rate over period t a 0 , a 1 , and a 2 = regression coefficients μ = error term The regression model was applied to historical annual data, and the regression coefficients were estimated as follows: a 0 = 0.0 a 1 = 1.1 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) is forecasted as follows for this year: Using any of the available information, should you as treasurer choose the forward hedge or the put option hedge? Show your work.

FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698
FindFind

International Financial Management

14th Edition
Madura
Publisher: Cengage
ISBN: 9780357130698

Solutions

Chapter 11, Problem 35QA
Textbook Problem

Forward versus Option Hedge As treasurer of Tempe Corp., you are confronted with the following problem. Assume the one-year forward rate of the British pound is $1.59. You plan to receive 1 million pounds in one year. A one-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 $0.04 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 D I N F t 1 + a 2 D I N T t + μ

where: e t = percentage change in the value of the British pound over period t

DINF t 1 = differential in inflation between the United States and the United

Kingdom in period t 1

DINT t =

average differential between the U.S.interest rate and the British interest rate over period t a 0 , a 1 , and a 2 = regression coefficients

μ = error term

The regression model was applied to historical annual data, and the regression coefficients were estimated as follows:

a 0 = 0.0 a 1 = 1.1 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) is forecasted as follows for this year:

Chapter 11, Problem 35QA, Forward versus Option Hedge As treasurer of Tempe Corp., you are confronted with the following

Using any of the available information, should you as treasurer choose the forward hedge or the put option hedge? Show your work.

This textbook solution is under construction.

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