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 $5,000,000,$ payable as $2,500,000$ on August $1$ and $2,500,000$ on November $1.$ Larkin derived its price quote of $5,000,000$ on April $1$ by dividing its normal U$.$S$.$ dollar sales price of $$5,100,000$ by the then current spot rate of $$\frac{1\mathrm{.}0200}{}.$

By the time the order was received and booked on May $1,$ the euro had strengthened to $$\frac{1\mathrm{.}0700}{},$ so the sale was in fact worth $5,000,000$$$\frac{1\mathrm{.}0700}{}=$$$5,350,000.$ Larkin had already gained an extra $$250,000$ 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 $$\frac{1\mathrm{.}0770}{}$ and the $6-$month forward quote was $$\frac{1\mathrm{.}0830}{}$lon.

b$.$ Hedge in the money market: Larkin could borrow euros from the Frankfurt branch of its U$.$S$.$ bank at $8\mathrm{.}43\%$ per annum.

c$.$ Hedge with foreign currency options: August put options were available at strike price of $$\frac{1\mathrm{.}0700}{}$ for a premium of $2\mathrm{.}0\%$ per contract, and November put options were available at $$\frac{1\mathrm{.}0700}{}$ for a premium of $1\mathrm{.}6\%.$ August call options at $$\frac{1\mathrm{.}0700}{}$ could be purchased for a premium of $3\mathrm{.}0\%,$ and November call options at $$\frac{1\mathrm{.}0700}{}$ were available at a $3\mathrm{.}0\%$ premium.

d$.$ Do nothing: Larkin could wait until the sales proceeds were received in A$$gust and November, hope the recent strengthening of the euro would continue, and sell the euros received for dollars in the spot market.

Larkin estimates the cost of equity capital to be $14\mathrm{.}5\%$ per annum. As a small firm, Larkin Hydraulics is unable to raise funds with long$-$term debt. U$.$S$.$ T$-$bills yield $3\mathrm{.}4\%$ per annum. What should Larkin do$?$