Question

Assume that Baton Rouge, Inc., expects to need S$1 million in one year. Using any relevant
information in part (a) of this question, determine whether a forward hedge, a money market
hedge, or a currency options hedge would be most appropriate. Then, compare the most
appropriate hedge to an unhedged strategy, and decide whether Baton Rouge should hedge its
payables position. What is the probability that the option hedge will cost more than the forward
hedge? What is the probability that the option hedge will cost more than an unhedged strategy?

Answer 1

Answer is attached below, the attachment of the question was blurred little bit. However i have solved

Answer
Forward hedge purchase
$1,000,000 one year forward:
$1,000,000 × $.62 = $620,000

Money market hedge
(i) Need to invest $952,381 ($1,000,000/1.05 = $952,381)
(ii) Need to borrow $571,429 ($952,381 × $.60 = $571,429)
(iii) Will need $622,857 to repay the loan in one year ($571,429 × 1.09 = $622,857)

Call option hedge where Exercise price is $.60 and premium is $.03)
Spot Rate Premium Exercise Per Unit Total Amount Probability
$.61 $.03 Yes $.63 $630,000 20%   
$.63 $ .03 Yes 0.63 $630,000 50%
$.67 $.03 Yes 0.63 $630,000 30%
The optimal hedge is the forward hedge

Now, the Unhedged Strategy

Possible Total Amount Paid For $500,000
Spot Rate Probability    $.61 $610,000 20%
$.63 $630,000 50 %
$.67 $670,000 30%
The forward hedge is preferable to the unhedged strategy because there is an 80 percent chance that it will outperform the unhedged strategy and may save the firm as much as $50,000.