Computer has a £1 million receivable that it expects to collect in one year. Suppose the interest rate on pounds is 15%. How could Dell protect this receivable using a money market hedge?
A) borrow £1 million pounds today
B) lend £1 million pounds today
C) borrow £869,565 pounds today
D) lend £986,754 pounds today

Question

Quizplus · Accepted Answer

To protect the receivable, Computer could enter into a forward contract to sell £1 million in one year at the current forward rate. Based on the interest rate parity, the forward rate can be calculated as follows:

Forward Rate = Spot Rate x (1+Domestic Interest Rate) / (1+Foreign Interest Rate)
Forward Rate = 1 x (1+0.15) / (1+0) = 1.15

Therefore, Dell could borrow £869,565 today (1/1.15) and invest it at the domestic interest rate of 15% to have £1 million in one year. At the same time, Dell could enter into a forward contract to sell £1 million in one year at the forward rate of 1.15. This would lock in the exchange rate and eliminate the risk of exchange rate fluctuations. When Computer collects the receivable in one year, Dell could use the proceeds to repay the loan and keep the profit from the interest rate difference.

Computer Has a £1 Million Receivable That It Expects to Collect