Question

Caterpillar, Inc., a US corporation, has sold some heavy machinery to an Italian company for 10,000,000 euros, with the payment to be received in six months. Because this is a sizable contract for the firm and because the contract is in euros rather than dollars, as the Lead Risk Analyst in Caterpillar’s heavy machinery division, you need to make a recommendation to the Treasurer regarding how Caterpillar should hedge the risk arising from this transaction exposure. You have gathered the following information. • The spot exchange rate is $1.1000/€ (i.e., 1 euro = 1.1000 US dollars) • The six month forward rate is $1.1050/€ • Caterpillar’s cost of capital is 10% per annum. • The euro 6-month borrowing rate is 4% per year (or 2% for 6 months) • The euro 6-month lending rate is 2% per year (or 1% for 6 months) • The US dollar 6-month borrowing rate is 5% per year (or 2.5% for 6 months) • The US dollar 6-month lending rate is 3% per year (or 1.5% for 6 months) • The premium on 6 month put options on the euro with strike rate $1.10 is 2.5%. You need to compare the hedging alternatives in order to make a recommendation. To that end, you are required to compute the net receipts in dollars of each hedging alternative. The phrase “net receipts in dollars” refers to the (actual or deemed) net cash inflow in dollars in six months time.

a) Suppose that Caterpillar chooses to hedge its transaction exposure using a forward contract. Will Caterpillar sell or buy euros forward? What will be the net receipts in dollars? In other words, what is the amount Caterpillar will receive in dollars in six months time?

b) Suppose Caterpillar chooses a money market hedge. What are the transactions that the firm will need to undertake to implement this hedge, and what will be the net receipts in dollars using this hedge?

c) Suppose Caterpillar decides to hedge using a put option. (i) Suppose that the spot rate in 6 months is $1.15 per euro. Will the option be exercised? What will be the net receipts in dollars? (ii) Suppose that spot rate in 6 months is $1.05 per euro. Will the option be exercised? What will be the net receipts in dollars?

d) Suppose that you strongly expect the euro to depreciate. In that case, which of the hedging alternatives would you recommend? Briefly justify your recommendation

e) Suppose that you strongly expect the euro to appreciate. In that case, which of the hedging alternatives would you recommend? Briefly justify your recommendation

f) By how much does the euro need to appreciate to make the put option at least as good an alternative (in retrospect) as the forward contract? In other words, by how much does the euro need to go up in value against the dollar in order for the net cash inflow from the put option to equal the cash inflow from the forward contract? Support your answer with calculations.

Answer 1

Part (a)

Caterpillar will receive payment in Euro, sell the Euro to get USD. Hence, Caterpillar should enter into forward contract to sell Euros.

Hence, the amount Caterpillar will receive in dollars in six months time = Receivable in Eur x Forward rate = €10,000,000 x $1.1050/€ = $ 11,050,000

Part (b)

Money market hedge:

Borrow the PV of receivable = €10,000,000 / (1 + rEuro, borrow x 6/12) = €10,000,000 / (1 + 2%) =  € 9,803,922

Sell these proceeds in the spot market to get the dollars = € 9,803,922 x spot rate = € 9,803,922 x $1.1000/€ = $ 10,784,314

Hence, the net receipts today in dollars using this hedge = $ 10,784,314. But as per question, all the net receipts means net receipts in dollar in six month time.

Hence, the net receipts in dollar in six month time = Net receipt today x (1 + rDollar, lend x 6/12) = 10,784,314 x (1 + 1.5%) = $ 10,946,078

Part (c)

Sub part (i)

Exercise price of the put otpiton, K = $ 1.10; Spot prie = S = $ 1.15

Since S > K, the put option will not excercisd.

the net receipts in dollars = Spot x Euro receivable - cost of put option x (1 + rDollar, borrow x 6/12) = 1.15 x 10,000,000 - 1.10 x 10,000,000 x 2.5% x (1 + 2.5%) = $ 11,218,125

Sub part (ii)

Exercise price of the put opiton, K = $ 1.10; Spot prie = S = $ 1.05

Since S < K, the put option will be excercisd.

the net receipts in dollars = Exercise price x Euro receivable - cost of put option x (1 + rDollar, borrow x 6/12) = 1.10 x 10,000,000 - 1.10 x 10,000,000 x 2.5% x (1 + 2.5%) = $ 10,718,125

Part (d)

The highest net exchange rate achieved is in case of the forward contract. If Euro is going to depreciate, Caterpillar should lock in as high a exchange rte as possible. Highest possible exchage rate is in case of forward contract. hence, it should enter into a forward contract to sell the Euros.

Part (e)

if euro is going to appreciate, there is a chance that the put option may not be exercised. In that case, the highest exchange rate achieved will be with the put option. Hence, the firm should enter into the put option to sell Euro at $ 1.10. If the spot rate turns out to be higher than this, the put option need not be exercised. So, the downside is protected but upside is unlimited.

Part (f)

Spot x Euro receivable - cost of put option x (1 + rDollar, borrow x 6/12) = Net proceeds from forward contract

Hence, S x 10,000,000 - 1.10 x 10,000,000 x 2.5% x (1 + 2.5%) = $ 11,050,000 (this figure is derived in part (a))

Hence, S x 10,000,000 - 281,875 = 11,050,000

Hence, S = (11,050,000 + 281,875) / 10,000,000 = $ 1.1332 / Euro

Hence, the euro need to go up by 1.1332 - current spot = 1.1332 - 1.10 = $ 0.0332 in value against the dollar in order for the net cash inflow from the put option to equal the cash inflow from the forward contract