Question

Larkin Hydraulics. On May 1, 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 as €2,000,000 on August 1 and €2,000,000 on November 1 . Larkin derived its price quote of €4,000,000 on April 1 by dividing its normal U.S. dollar sales price of $4,280,000 by the then current spot rate of $1.0700/€. By the time the order was received and booked on May 1 , the euro had strengthened to $1.1200/€, so the sale was in fact worth €4,000,000×$1.1200/€=$4,480,000. Larkin had already gained an extra $200,000 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. Four approaches were possible:

a. Hedge in the forward market: The 3-month forward exchange quote was $1.1280/€ and the 6-month forward quote was $1.1340/€.
b. Hedge in the money market: Larkin could borrow euros from the Frankfurt branch of its U.S. bank at 8.13% per annum.
c. Hedge with foreign currency options: August put options were available at strike price of $1.1200/€ for a premium of 1.8% per contract, and November put options were available at $1.1200/€ for a premium of 1.6%. August call options at $1.1200/€ could be purchased for a premium of 2.8%, and November call options at $1.1200/€ were available at a 3.0% premium.
d. Do nothing: Larkin could wait until the sales proceeds were received in August and November, hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market.

Answer 1

Larkin Hydraulics is considering whether to hedge against exchange rate risk after the euro strengthened post-sale of a turbine to a Dutch company, increasing the U.S. dollar value of the sale. The company evaluates four hedging strategies, weighing the cost and potential benefits. This decision is influenced by examples showing how currency strengths impact exports.

Step-by-step explanation:

The question involves Larkin Hydraulics considering different methods to hedge against potential exchange rate fluctuations after selling a 12-megawatt compression turbine to a company in the Netherlands. Larkin Hydraulics priced their turbine by converting the U.S. dollar sales price to euros based on the exchange rate at that time. Due to exchange rate changes, the actual euro sale was worth more in dollars by the time the sale was booked. Considering this, Larkin's director of finance evaluates four hedging options to mitigate the risk of a reversal in the euro's strength:

1. Using forward exchange contracts at quoted rates,
2. Borrowing euros at an interest rate provided by the Frankfurt branch of their U.S. bank,
3. Purchasing foreign currency options with specific premiums and strike prices, and
4. Doing nothing and possibly benefiting from continued euro strengthening when converting sales proceeds to dollars.

The decision involves understanding the impact of exchange rates as shown in examples provided by LibreTexts. A stronger euro can discourage exports for European firms and conversely, a weaker U.S. dollar can encourage U.S. exports.