Current one-year interest rate for USD LIBOR: 5.25%
Current one-year interest rate for Sterling (UK) LIBOR: 4.25%
Current spot ex-rate (S): = $1.5200/£
Current one-year forward rate (F) = $1.5428/£
Caterpillar (CAT), a U.S.-based MNC, has a £12M account payable in one year to a U.K. company for some engines it will purchase from a British company.
a. ESSAY: In a full essay of a paragraph or more, explain why and how CAT faces transaction currency risk. What is the specific currency risk that CAT is worried about? Explain why.
b. Calculate and report the dollar cost of the payable in one year if CAT uses a forward hedge at the forward rate (F) above.
c. Calculate the dollar cost of the payable in one year if CAT uses a money market hedge. Clearly explain in words each of the steps, along with your calculations.
d. Which option do you recommend and why? Refer specifically to your results from both parts b and c above, and calculate the difference in the two options. Ignore transaction costs. BP call options are available for $0.0135/£ at an exercise (strike) price of $1.5300/£ and CAT uses these call options to hedge ex-rate risk.
e. Show a carefully labeled and titled payoff diagram for these call options. (Please do no copy payoff diagrams directly from the lecture notes.)
f. Calculate and report the cost of the options, including the opportunity cost.
g. Calculate CAT’s dollar cost of the payable in one year for the following ex-rates in one year: $1.5850/£, $1.5650/£, $1.5150/£ and $1.4950/£ (in that exact order, please do not reverse or change). Show 4 separate parts for each ex-rate: i) the net gain or loss on the options including the opportunity cost, ii) the dollar cost of buying BPs at the spot rate, iii) the net total dollar cost of the order that includes the cost of buying the BPs at the spot rate and the profit or loss on the options contracts, and iv) the effective ex-rate. Assume an opportunity cost of 5.25% for one year to buy the options, and include that in your analysis.
h. ESSAY: Summarize the results of using a call option to hedge currency risk in a complete essay of a paragraph or more, and refer to your numerical results form part g.