Your firm is a U.K.-based exporter of British bicycles.You have sold an order to an Italian firm for €1,000,000 worth of bicycles.Payment from the Italian firm (in €)is due in twelve months.Your firm wants to hedge the receivable into pounds.Not dollars.Interest rates are 3% in €,2% in $ and 4% in £. Detail a strategy using spot exchange rates and borrowing or lending that will hedge your exchange rate risk.

Question

Your firm is a U.K.-based exporter of British bicycles.You have sold an order to an Italian firm for €1,000,000 worth of bicycles.Payment from the Italian firm (in €)is due in twelve months.Your firm wants to hedge the receivable into pounds.Not dollars.Interest rates are 3% in €,2% in $ and 4% in £.  Detail a strategy using spot exchange rates and borrowing or lending that will hedge your exchange rate risk.

Quizplus · Accepted Answer

The strategy of borrowing the amount equivalent to the receivable and converting it to pounds using spot exchange rates will hedge the exchange rate risk. By borrowing €970,873.79 at an interest rate of 3%, the firm will owe €1m in a year, which will be financed with the receivable. Converting the borrowed amount to dollars at the spot exchange rate of $1.20, the firm receives $1,165,048.54, which is then converted to pounds at the spot exchange rate to receive £728,155.34. This strategy hedges the exchange rate risk without using forward contracts, which may have additional costs and counterparty risks.

Your Firm Is a U