Question

Larkin Hydraulics, a wholly owned subsidiary of Caterpillar (U.S.), sold a 12 megawatt compression turbine to Rebecke-Terwilleger Company of the Netherlands for €4,000,000, payable in three months (90 days). Larkin derived its price quote of €4,000,000 by dividing its normal U.S. dollar sales price of $4.320,000 by the then current spot rate of $1.0800/€.

Four approaches are possible:

1. Hedge in the forward market. The 3-month forward exchange quote was $1.1060/€.

2. Hedge in the money market. Larkin could borrow euros in the Libor market at 8% per annum and invest in € at 5% p.a. In

the USD Libor market the firm can borrow at 7% p.a. and invest at 4% p.a.

3. Hedge with foreign currency options. August put options were available at strike price of $1.1000/€ for a premium of 2.0%

per contract. August call options with a strike at $1.1000/€ could be purchased for a premium of 3.0%.

4. Do nothing. Larkin could wait until the sales proceeds were received in August and sell the euros received for dollars in the

spot market.

Larkin’s banker forecasts that the exchange rate in 90 days will be $1.1400/€.

What should Larkin do?

Answer 1

	The amounts receivable under the four options are worked out below:
1]	Forward hedge:
	Amount receivable = 4000000*1.1060 =	$   44,24,000
2]	MMH:
	As the receivable is in Euros, the firm should
	create liability in Euros, which will have a value
	of Euros 4000000 in 90 days.
	Hence, it should borrow euros 4000000/1.02 =	€   39,21,569
	This should then be converted to $ to get 3921569*1.08 =	$   42,35,294
	These dollars would be invested for 90 days to get 4235294*1.01 =	$   42,77,647
	This would be the effective amount receivable
	under the MMH.
3]	Amount realizable under the put option, if exercised = 4000000*1.1 =	$   44,00,000
	Less: FV of option premium = 4000000*2%*1.0175 =	$         81,400
	Net amount receivable under the put option	$   43,18,600
4]	Amount realizable under do nothing if spot is $1.14 after 90 days = 4000000*1.14 =	$   45,60,000
5]	Larkin can leave the exposure unhedged if he
	has faith in his banker's prediction as it would
	give the highest amount.
	If he decides not to rely on the banker's
	prediction of the future spot, he should go for
	the forward hedge which, gives the next highest
	amount.