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?

Answer 1

Answer :

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

S.No	Particulars	Amount	Amount
1	Hedge via Forward	-	-
	Receivable	€ 10,00,000	-
	Forward Rate	1,1050 US $ / 1 €	-
	Total payment received in forward contract	-	$11,050,000

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

S.No	Particulars	Amount	Amouont
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	-
	US $ Received	$10,784,313.73	-
	Invests above money @1.5%	$161,764.71	-
	Money Received after 6 months	-	$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

S. No	Particulars	Amount	Amount
3	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*$0.0275	$275,000.00	-
	Add : Cost on put premium	$13,750.00	-
	($275,000*10% of 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.

S. No	Particulars	Amount	Amount
3	Receivable	€ 10,000,000	-
	Option not exercised so sell at $1.10	$1.10	-
	Total	-	$11,000,000
	Less :	-	-
	Put premium paid	-	-
	(€ 10,000,000*$0.0275	$275,000.00	-
	Add : Cost on put premium	$13,750.00	-
	($275,000*10% of 6 months)	-	-
	Total cost on put option	-	$288,750
	Money Received after 6 month	-	$10,711,250

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