International Financial Management 2nd Edition by Geert Bekaert ,Robert Hodrick

Exercise 17

Caterpillar is selling earthmoving equipment to an Indonesian construction company. Caterpillar must choose whether to denominate the contract in U.S. dollars or in Indonesian rupiah. Suppose that the spot exchange rate is IDR9,150 / $ and that there is no forward market. Suppose, too, that there is a possibility that the rupiah will be devalued relative to the dollar during the next year. If Caterpillar prices the contract in dollars, it will charge $15,000,000 and will expect to be paid in 1 year. It is also willing to discuss pricing the machines in rupiah. The Indonesian firm thinks that there is a 60% chance the exchange rate will remain the same and a 40% chance it will increase to IDR9,300/ $. Caterpillar thinks that there is a 65% probability of the exchange rate remaining the same and a 35% probability that it will increase to ID9,450/$. How should the deal be priced, and who will bear the risk of devaluation of the rupiah