Hedge Decision on a Project
Response to the following problem:
Carlotto Co. (a U.S. firm) will definitely receive 1 million British pounds in 1 year based on a business contract it has with the British government. Like most firms, Carlotto Co. is risk averse and only takes risk when the potential benefits outweigh the risk. It has no other international business and is considering various methods to hedge its exchange rate risk. Assume that interest rate parity exists. Carlotto Co. recognizes that exchange rates are very difficult to forecast with accuracy, but it believes that the 1-year forward rate of the pound yields the best forecast of the pound's spot rate in 1 year. Today the pound's spot rate is $2.00, while the 1-year forward rate of the pound is $1.90. Carlotto Co. has determined that a forward hedge is better than alternative forms of hedging.
Should Carlotto Co. hedge with a forward contract or should it remain unhedged? Briefly explain.