On June 1, Larkin Hydraulics, a wholly owned subsidiary of Caterpillar (US), sold a 12-megawatt compression turbine to Rebecke-Terwilleger Company of the Netherlands for 3,000,000, payable on September, 1. Larkins director of finance is considering whether to hedge against transaction currency risk, and has the following information:

• Spot exchange rate on June 1: $1.20/
• 90 day forward rate $1.18/
• 90 day $ borrowing rate: 11% p.a.
• 90 day $ investment rate: 7%
• 90 day borrowing rate: 14% p.a.
• 90 day investment rate: 8% p.a.
• Cost of capital: 12% p.a.
• September 3-month put option for 1m: strike $1.185/ and premium of 2% ($0.0237/)
• September 3-month call option for 1m: strike $1.185/ and premium of 1% ($0.01185/)

Answer the following questions:

1. If Larkin decides not to hedge, what will they expect to receive in dollars? What is their risk?
2. What would Larkin receive if it hedges its transaction exposure with a forward?
3. What would Larkin receive if it decides to carry out a money market hedge?
4. What alternative is better, b or c? Explain.
5. If Larkin decided to hedge via an option, what should it do?
6. What alternative is better, b, c or e? Explain.
7. If the exchange rate on September 1 was $1.20/, what alternative would be better?