Reference no: EM133119096
On May 1st, 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 €2,000,000 on August 1st and €2,000,000 on November 1st. Larkin derived its price quote of €4,000,000 on April 1st by dividing its normal U.S. dollar sales price of $4.320,000 by the then current spot rate of $1.0800/€.
By the time the order was received and booked on May 1st, the euro had strengthened to $1.1000/€, so the sale was in fact worth €4,000,000 x $1.1000/€ = $4,400,000. Larkin had already gained an extra $80,000 from favorable exchange rate movements. Nevertheless Larkin's director of finance now wondered if the firm should hedge against a reversal of the recent trend of the euro. There are four possible approaches:
1) Hedge with forwards
2) Hedge with Money Market Funds
3) Hedge with Options
4) Do nothing and bear the risk of the exchange rate reversing
Given the following what is the outcome if forwards are used to hedge the transaction?
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Assumptions
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Values
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90-day Forward rate, $/€
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$1
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180-day Forward rate, $/€
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$1
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US Treasury bill rate
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3.600%
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Larkin's borrowing rate, Euros, per annum
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7.92%
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Larkin's cost of equity
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12.87%
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Options on Euros
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Strike ($/euro)
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Call Option
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Put Option
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August maturity options
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$1.1000
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2.87%
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1.93%
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November maturity options
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$1.1000
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2.66%
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1.20%
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