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 . 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 . 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

Borrowing €970,873.79 eliminates the exchange rate risk as the receivable is being financed in €, and the borrowing of € is being paid back in €. By converting €970,873.79 to dollars at spot ($1.20 per €1), the $ value received is $1,165,048.54. By converting the $ to pounds at spot ($1.00 per £0.625), the £ value received is £728,155.34. This hedges the exchange rate risk and provides a specific amount of pounds upon receiving the payment from the Italian firm.

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