Your firm is an Italian exporter of bicycles.You have sold an order to a British firm for £1,000,000 worth of bicycles.Payment from the customer (in pounds sterling)is due in 12 months.Use a money market hedge to redenominate this one-year receivable into a euro-denominated receivable with a one-year maturity. The following were computed without rounding.Select the answer closest to yours.

Question

Your firm is an Italian exporter of bicycles.You have sold an order to a British firm for £1,000,000 worth of bicycles.Payment from the customer (in pounds sterling)is due in 12 months.Use a money market hedge to redenominate this one-year receivable into a euro-denominated receivable with a one-year maturity.  The following were computed without rounding.Select the answer closest to yours.

Quizplus · Accepted Answer

To redenominate the receivable into euro, we will sell pounds forward and buy euro.
First, we need to calculate the forward rate: 
GBP/EUR spot rate = 1.1250
GBP interest rate = 0.25%
EUR interest rate = 0%
Using the interest rate parity, we can calculate the forward rate as:
1.1250 x (1 + 0.25%) / (1 + 0%) = 1.1284
Next, we can calculate the amount of euro we will receive in 12 months:
£1,000,000 / 1.1284 = €887,380.35
To eliminate the exchange rate risk, we will sell pounds forward at the 1-year forward rate of 1.1284, which means we will receive:
£1,000,000 x 1.1284 = €1,128,400
However, we need to account for the interest rate differential between the two currencies. We will invest the euro proceeds at the euro interest rate for 12 months and convert it back to pounds at the spot rate in 12 months.
€1,128,400 x (1 + 0%) = €1,128,400
At the end of 12 months, we will convert the euro proceeds back into pounds at the spot rate. Assuming the spot rate at that time is the same as the current spot rate of 1.1250, we will receive:
€1,128,400 / 1.1250 = £1,002,037.78
This is a pound-denominated amount, but we want it to be euro-denominated. To convert it to euro, we divide by the spot rate:
£1,002,037.78 / 1.1250 = €1,244,212.10
Therefore, the answer is B.

Your Firm Is an Italian Exporter of Bicycles