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 Caterpillars 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 Caterpillars 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 you strongly expect the euro to depreciate In that case, which of the hedging alternatives would you recommend Briefly justify your recommendation (2 points) b) 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) c) 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)

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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

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 Caterpillars 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/
Caterpillars 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 you strongly expect the euro to depreciate. In that case, which of the hedging alternatives would you recommend? Briefly justify your recommendation (2 points)

b) 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)

c) 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)