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 $.04 per unit. Your forecast of the percentage change in the spot rate was determined from the following regression model:

et = a0 + a1DINFt-1 + a2DINTt + µ

Where

et = percentage change in British pound value over period t

DINFt-1 = differential in inflation between the United States and the United

Kingdom in period t - 1

DINTt =average differential between U.S. interest rate and British interest

rate over period t

a0, a1, and a2 = regression coefficients

µ = error term

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

a0 = 0.0

a1 =1.1

a2 =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 (DINTt) is forecasted as follows for this year:

Forecast of DINTt Probability

1% .........40%

2 .......... 50

3 .......... 10

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