1. Caterpillar Inc. just signed contracts to supply mining equipment to Australian mining companies BHP Billiton and Rio Tinto for a total bill of AUS $36,000,000 payable in one year. Caterpillar Inc. is concerned about a potential appreciation of the US dollar against the AUS dollar (amidst expectations that the US Federal Reserve may soon begin to unwind its bond purchase program) and would like to hedge this currency exposure. Caterpillar Inc. has approached you (a currency derivatives dealer) to discuss hedging alternatives.

The current spot exchange rate is quoted at US $0.91/AUS $ and the one-year forward exchange rate is quoted at US $0.88/AUS $. Currently, one-year money market rates are 0.25% in the US and 2.5% in Australia. A one-year put option on AUS dollars with a strike/exercise price of $0.90/AUS $ is selling at a premium of US $0.02/AUS $. You plan to discuss three hedging alternatives with Caterpillar Inc., a forward hedge, a money market hedge and an option hedge.

1. Should Caterpillar use a long or short forward contract on the AUS $ to hedge currency risk? What would be Caterpillars expected US dollar proceeds if it decides to hedge using a forward contract?
2. What transactions would Caterpillar need in order to carry out a money market hedge? Compute the expected US dollar proceeds if Caterpillar decides to use a money market hedge.
3. Which alternative is superior; the forward hedge or money market hedge? Why arent the dollar proceeds from both alternatives equal?
4. At what forward exchange rate will Caterpillar be indifferent between the forward hedge and the money market hedge?
5. Compute the expected US dollar proceeds if Caterpillar decides to hedge using put options on the AUS dollar. You assume that the current forward exchange rate as an unbiased predictor of the future spot exchange rate one year from now.
6. At what future spot exchange rate do you think Caterpillar will be indifferent between the option hedge and money market hedge?