*A. We are Bechtel, a private US construction firm. We bid to develop the airport and the surrounding area for Sweden. We are not sure whether the Swedish transportation authorities will grant us the business, but we hope they will. If we are awarded the contract, for which we bid $ 1 billion, we shall need to buy Swedish materials and labor for 2 years. Assume that the purchases we need to make are in one year. The project will be completed in two years from the present. We expect the Swedish krona will revalue in the next 2 years, but we do not know definitely. We have two choices. One is to hedge and paying for the labor and materials in the one year, and the other is to leave an open position. If we hedge, we shall hedge for one year assume, and it will last for 2 years.

Answer:

Step-by-step explanation:

1) Mathematically 

The calculation of total amount of baht to be paid over 2 years under through financial instruments is shown below :

Hence, the total amount of baht to be paid over 2 years is found to be minimum when Bechtel hedges its position through options with an exercise price of 25 baht / $ at 3% premium.

This option will give Bechtel the right to exchange $1 billion at 25 baht / $ after 2 years.

Conclusion : The best solution for Bechtel would be to hedge its position using the above-mentioned options. 
 

2) Verbally

Bechtel should hedge its foreign exchange exposure because the exchange rate (baht / $) may fluctuate over the life of the project which may impact the overall profitability of the project. The exchange rate (baht / $) may change due to various reasons such as :

Political instability in Thailand or US

Change in inflation rates in Thailand or US

Change in interest rates in Thailand or US

Increase in the value of baht

Decrease in the value of dollars

By hedging its foreign exchange exposure, Bechtel can focus on its project on other core activities and increase overall profitability of its business. 

Conclusion : Hence, the best solution for Bechtel would be to hedge its position and not leave its currency exposure open.