Question

1.         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? (2 points)

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? (3 points)

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? (2 points)

(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? (2 points)

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 (2 points)

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 (2 points)

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. (2 points)

Answer 1

(a) In forward contract Euro sell in forward contract.

Sr.No.	Particular	Amount	Amount
1	Hedge via Forward
	Receivable	€        10,000,000
	Forward Rate	1.1050 US $ / 1 €
	Total Payment received in Forward Contract		$        11,050,000

(b) If Hedge via money market Borrow euro (Equivelent to €10,000,000 after interest on borrowing) and invest into US $.

Sr.No.	Particular	Amount	Amount
2	Hedge via Money Market Hedge
	Receivable	€        10,000,000
	(A) Borrow Money equivelent to € 10,000,000 after 6 month including interest (€ 10,000,000 / (1 + 0.02)	€    9,803,921.57
	(B) Convert above to US $ @ spot rate @ $1.1000 / € 1	$1.10
	US $ Received	$ 10,784,313.73
	Invest above money @ 1.5%	$        161,764.71
	Money Received after 6-Month		$ 10,946,078.43

(c) Hedge using Put option.

(1) If spot rate $1.15/ € 1 then put option not exercised means put option lapse.

Sr.No.	Particular	Amount	Amount
3	Hedge via Put Option
	Receivable	€        10,000,000
	Option not exercised so sell at $1.15	$1.15
	Total		$        11,500,000
	Less :
	Put Premium Paid
	(€ 10,000,000 x $ 0.0275)	$        275,000.00
	Add : Cost on Put Premium	$          13,750.00
	($ 275,000 x 10% fo 6-Months)
	Total Cost on Put Option		$              288,750
	Money Received after 6-Month		$        11,211,250

(2) If spot rate $1.15/ € 1 then put option exercised.

Sr.No.	Particular	Amount	Amount
3	Hedge via Put Option
	Receivable	€        10,000,000
	Option exercised so sell at $1.10	$1.10
	Total		$        11,000,000
	Less :
	Put Premium Paid
	(€ 10,000,000 x $ 0.0275)	$        275,000.00
	Add : Cost on Put Premium	$          13,750.00
	($ 275,000 x 10% fo 6-Months)
	Total Cost on Put Option		$              288,750
	Money Received after 6-Month		$        10,711,250

(d) If Euro depreciate means US $ appreciate so forward contract is better which give higher receivable.

Spot rate $1.10 / € 1 if Euro depreciate than rate of 1 euro is below $1.10 then put option exercise.

Money received in Forward Contract = $        11,050,000

Money received in Put option = $        10,711,250

Extra money received   $ 338,750

Money received in Forward Contract = $        11,050,000

Money Market Hedge = $        10,946,078

Extra money received    = $ 103,922

If strongly expect that euro depreciate then advisable to cover risk in forward contract.

(e)

If Euro appreciate then US $ depreciate then in case of receivable open position is good but better to cover risk against any unfavorable situation.In forward rate company not able to take advantage of Euro appreciation as rate is fixed in forward contract.

If strongly expect appreciation in Euro then advisable to cover in put option as the put option give cover if rate below $ 1.10 and upper side company will not exercised put option and take advantage of appreciation.

In this question not consider money market hedge as euro appreciate than money market have lower receipt.

(f)

Particular	Amount
Total Receipt in Forward Contract	$   11,050,000
Add : Cost of Put Option	$         288,750
Total receipt requred in Put Option	$   11,338,750
Receivable Euro	€   10,000,000
Exchange Rate	$           1.1339

Euro Appreciate in value up by = $1.1339 - $ 1.1000 = $0.0339

Euro Appreciate in % = ($0.0339 / $ 1.1000) x 100 = 3.0818%

or

Particular	Amount
Forward Rate	$           1.1050
Add : Cost of Put Option per Euro	$           0.0289
($288,750 / € 10,000,000)
Exchange Rate	$           1.1339

Euro Appreciate in value up by = $1.1339 - $ 1.1000 = $0.0339

Euro Appreciate in % = ($0.0339 / $ 1.1000) x 100 = 3.0818% (6-Month)

Euro need to appreciate by 3.0818% (6-Month) or by $0.0339 to make the put option at least as good an alternative (in retrospect) as the forward contract.

Working Note

WN-1 Calculation of Put premium

Strike Price $ 1.10

Premium 2.50%

Premium per Euro = $1.10 x 2.50% =  $0.0275