Your firm is an Italian importer of British bicycles. You have placed an order with a British firm for £1,000,000 worth of bicycles. Payment (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 importer of British bicycles. You have placed an order with a British firm for £1,000,000 worth of bicycles. Payment (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 euros, we need to borrow pounds today and convert them into euros. The borrowed pounds will be invested in the euro money market at the eurozone prevailing interest rate. This investment should repay the borrowed pounds and the interest, leaving us with our euro-denominated receivable in 12 months that we can use to repay the loan. 
Calculation:
1,000,000 GBP x (1.00 + 1.00% x 1) = 1,010,000 GBP (amount to be borrowed)
1,010,000 GBP / 1.10 = 918,181.82 EUR (amount received after converting pounds to euros)
918,181.82 EUR x 1.35% x 1 = 12,362.32 EUR (interest earned on investment)
918,181.82 EUR + 12,362.32 EUR = 930,544.14 EUR (total amount in euros received after converting and investing)
€1,244,212.10 is the closest answer.

Your Firm Is an Italian Importer of British Bicycles