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 6 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 $1.25/€
• The six month forward rate is $1.26/€
• Caterpillar’s cost of capital is 10% per annum.
• The euro 6-month borrowing rate is 4% (or 2% for 6 months)
• The euro 6-month lending rate is 2% (or 1% for 6 months)
• The US dollar 6-month borrowing rate is 5% (or 2.5% for 6 months)
• The US dollar 6-month lending rate is 3% (or 1.5% for 6 months)
• The premium on 6 month put options on the euro with strike rate $1.25 is 1.5%.
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 6 months’ time. As you know, in general, adding cash flows occurring at different points in time is inappropriate unless the cash flows have been appropriately present-valued or future-valued.
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?
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 $1.30 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 a better alternative than 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.