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 rela- tive to the dollar during the next year. If Caterpil- lar 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 tax rate Company Sales $4,500 $5,700 and a 40% chance it will increase to IDR9,300 >$. 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?
Manufacturing Affiliate (35%
Distribution
Affiliate (55% Consolidated
rupiah. The Indonesian firm thinks that there is a
60% chance the exchange rate will remain the same
tax rate) tax rate) Company
Sales $4,500 $5,700
Less Cost
of Goods Sold
Less
Operating Expenses
Taxable
Income Less Income
Taxes
2,600
1,000 450