Your firm is a U.K.-based importer of bicycles. You have placed an order with a Swiss firm for SFr. 1,000,000 worth of bicycles. Payment (in Swiss francs) 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.
A)£500,000
B)£464,874.41
C)£446,730.77
D)£509,900.99

Question

Your firm is a U.K.-based importer of bicycles. You have placed an order with a Swiss firm for SFr. 1,000,000 worth of bicycles. Payment (in Swiss francs) 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.
A)£500,000 
B)£464,874.41 
C)£446,730.77 
D)£509,900.99

Quizplus · Accepted Answer

To redenominate the receivable, we need to do the following:
1. Borrow the present value of the CHF receivable in pounds for one year.
2. Use the pounds to buy euros at the spot rate.
3. Invest the euros in a one-year deposit at the euro-interest rate.
The amount of pounds borrowed will be the present value of the CHF receivable.
PV(CHF receivable) = CHF 1,000,000 / (1 + 0.02) = CHF 980,392.16
We can then borrow this amount in pounds for one year at the pound-interest rate.
PV(CHF receivable) = £ PV(CHF receivable) / (1 + 0.04)
£ PV(CHF receivable) = PV(CHF receivable) x (1 + 0.04) = CHF 980,392.16 x 1.04 = £964,874.41
We can use these pounds to buy euros at the spot rate.
£964,874.41 / 1.20 = €804,062.01
Finally, we can invest the euros in a one-year deposit at the euro-interest rate.
€804,062.01 x 1.03 = €828,882.39
At the end of the year, we will have €828,882.39, which we can convert back to pounds using the one-year euro-pound exchange rate.
€828,882.39 x 0.95 = £787,437.91
Our pound outflow will be:
£ PV(CHF receivable) = £964,874.41
Our pound inflow will be:
£787,437.91
Our money market hedge has reduced our foreign exchange risk, but it has also generated a cost of:
£964,874.41 - £787,437.91 = £177,436.50
Therefore, the best choice is B, £464,874.41, which is the present value of the CHF receivable in pounds minus the cost of the hedge.

Your Firm Is a U