Cross-Hedging Strategy
Response to the following problem:
Assume that the country of Dreeland has a currency (called the dree) that tends to move in tandem with the Chilean peso and is expected to continue to move in tandem with the Chilean peso in the future. Indianapolis Co., a U.S. firm, has a large amount of receivables denominated in dree. It expects that the dree will depreciate against the dollar over time.
There are no derivatives available on the dree. Indianapolis Co. considers the following strategies to reduce its exchange rate risk:
a. use a money market hedge in which it converts dollars into dree and maintains a deposit denominated in dree for one year,
b. use a forward contract to purchase Chilean pesos forward,
c. sell a put option hedge on Chilean pesos,
d. purchase a call option on Chilean pesos,
e. use a forward contract in which it sells Chilean pesos forward. Which strategy is most appropriate?