Caterpillar $($U$.$S$.)$ just purchased a Korean company that produces plastic nuts and bolts for heavy equipment. The purchase price was Won$7,030$ million. Won$1,000$ million has already been paid, and the remaining Won$6,030$ million is due in six months. The current spot rate is Won$1200/$$$,$ and the $6-$month forward rate is Won$1260/$$$.$ Caterpillar can invest at the rates given below, or borrow at $2\%$ per annum above these rate. Caterpillar's weighted average cost of capital is $10\%.$ As you compare $1)$ no hedge; $2)$ forward hedge; $3)$ money market hedge; $4)$ option hedge, assume the spot rate $6$ mo from now turns out to be what Caterpillar expects. Assumptions Values Purchase price of Korean manufacturer, in Korean won $7,030,000,000$ Less initial payment, in Korean won $(1,000,000,000)$ Net settlement needed, in Korean won, in six months $6,030,000,000$ Current spot rate $($Won$/$$$)1,200$ Six month forward rate $($Won$/$$$)1,260$ Caterpillar's expectation of spot rate $6$ mo from now $1,300$ Caterpillar cost of capital $($WACC$)10\mathrm{.}00\%$ Options on Korean won: Call Option Put Option Strike price $($won$/$$$)1,200\mathrm{.}001,200\mathrm{.}00$ Option premium $($percent$)3\mathrm{.}000\%2\mathrm{.}400\%$ United States Korea Investment $($not borrowing$)$ interest rate $4\mathrm{.}000\%16\mathrm{.}000\%$ Borrowing premium of $2\mathrm{.}000\%2\mathrm{.}000\%2\mathrm{.}000\%$ Borrowing rate $6\mathrm{.}000\%18\mathrm{.}000\%$ Risk Management Alternatives Values Certainty $1.$ Remain uncovered, making the won payment in $6$ months at the spot rate in effect at that date Account payable $($won$)6,030,000,000$ Spot rate in six months $1,300$ Cost of settlement in six months $($US$$)4,638,4622.$ Forward market hedge. Buy won forward six months Account payable $($won$)6,030,000,000$ Forward rate $($won$/$$$)1,260$ Cost of settlement in six months $($US$$)4,785,7143.$ Money market hedge. Exchange dollars for won now, invest for six months. Account payable $($won$)6,030,000,000$ Need to discount for $6$ months $1\mathrm{.}0800$ Won needed now $($payable$/$discount factor$)5,583,333,333$ Current spot rate $($won$/$$$)1,200$ US dollars needed now $4,652,778$ Carry forward rate for six months $($WACC$)1\mathrm{.}0500$ US dollar cost, in six months, of settlement $4,885,4174.$ Call option hedge: buy call on won $($long$-$call on won$)$ Option principal $6,030,000,000$ Current spot rate $($won$/$$$)1,200$ Premium cost of option $(\%)0\mathrm{.}0300$ Option premium $($principal$/$spot rate x $\%$ pm$)150,750$ not exercise option will NOT be exercised $4,638,462$ Premium carried forward six months $($WACC$)158,288$ Total net cost of call option hedge if exercised $4,796,749$ Between $2)$ and $3)-$ both locked$-$in now$-,2)$ is clearly better as it involves less payment value $($A$/$P$).$ Since the outcomes of $1)$ and $4)$ depend on future spot rates, one cannot determine, ex$-$ante, which is best strategy. However, assuming the future spot turns out to be $1300($much weaker won$),$ then ex$-$post $($i$.$e$.$ with the benefit of hindsight$),1)$ no$-$hedge turns out to be the best. Try different future spot rates, and see how outcomes change! What if it turns out to be $1,100$ or $1,000?$