Money Market Hedge

A money market hedge is a technique of using borrowings and lending transactions in foreign currencies to preserve the value of home currency during foreign currency transactions. It has become a key tool for exporters to lower their transaction risk while conducting transactions in foreign exchange.

The technique of hedging the risk depends on whether a firm has to pay or receive the payment in foreign currency. It also protects retail investors and small businesses from currency fluctuations bypassing forward contracts or futures markets during the process of hedging currency risk. It becomes a less complicated process to hedge the transaction exposure for large corporations.

• A money market hedge is a procedure of borrowing in dollars and then investing in foreign currency to manage the risk arising out of investing money market.
• It provides an extra layer of security and lowers the risk of exporters transacting in foreign currency during foreign exchange transactions.
• It has the advantage of being a safe and secure form of investment for investors that give fixed returns to them, whereas it offers a lower interest rate without any option for long-term investment. 
• It differs from the forward hedge as it has a wider scope of application than the forward hedge, which has a narrower scope.

A money market hedge can be explained as a hedge to thwart foreign currency risk by utilizing the borrowings or depositing an appropriate amount sum for fixing receipts and payments related to local currency. Every business involved in foreign currency transactions that have the payment date and receipt delayed faces the risk of fluctuating foreign currency risk. It happens because the foreign currency value may get changed during the two dates of occurrence of the transaction and the payment or receipt date. Usually, importers intend to pay foreign currency at a specified future date.

That firm would estimate the present value of the quantity of the foreign currency payable at the prevalent lending rate of foreign currency. Afterward, the trader would convert it into the corresponding value of a local currency at the existing spot exchange rate to lend it for the given duration. As a result, the trader gets a method to convert their commitment into local currency payables. Therefore, the trader eliminates the foreign exchange currency risk from the transactions.

If one has just decided to start investing, then all the money need not get invested in securities, bonds, and commodities. However, they have risk elements, so one should try to invest in the money market to hedge that risk. Money markets comprise instruments like bankers' acceptance, certificates of deposit (CDs), commercial paper, and Treasury bills.

The investors conduct hedging in the money market in the following manner.

Part 1: Dealing With Receiving Foreign Currency

When an individual or company expects to receive payment in foreign currency, it gets exposed to reduced value in comparison to local currency on the date of its receipt. Hence, the company or individual can hedge it, using the money market against the currency risk by foreign currency borrowings in an amount equal to the present value of the receivable sum soon. 

It can be calculated using the below money market hedge formula:

Foreign Loan (Fl) = Foreign Receipt/ (1+rfb)^n

Here,

• rfb = foreign currency borrowing rate during a said period 
• n = the number of periods between the present & date of receipt.

At the end of the exposure tenure, the loan repayable would be exactly equal to that amount received in foreign currency received from the customer would then get to repay the loan. It gets done by converting the foreign loan into domestic currency using the spot exchange rate where:

Domestic Deposit (Dd) = Fl × Spot Rate

However, as the company earned interest on its deposited domestic currency, the final domestic value is calculated as:

Final Domestic Value = Dd + (1+rdd) ^n

Here, 

• rdd = domestic deposit rate for the tenure, and 
• n = number of periods. 

Finally, the company gets its exchange rate fixed by hedging as below:

Effective Exchange Rate = Final Domestic Value/ Foreign Receipt

Part 2: Dealing With Foreign Currency Payments

When an individual or company expects to pay the supplier in foreign currency, it gets exposed to increased value in comparison to local currency on the date of its receipt. Hence, the company or individual hedges it using the money market against the currency risk by foreign currency deposits in an amount equal to the present value and the date of payment shortly. 

Moreover, its foreign Deposit acts as present value. Therefore, the foreign currency deposited in the bank should accumulate into the same amount as payable to the supplier by the importer at the end of the deposit period.

Money market hedge payable can be calculated using the below formula:

Foreign deposit (Fd) = Foreign payment/ (1+rfb)^n

Here,

• rfb = foreign currency deposit rate during a said period 
• n = the number of periods between the present & date of receipt.

At the end of the exposure tenure, the deposit amount plus interest would equal that amount payable in foreign currency to the customer, who would then get to repay the dues. Furthermore, one can safely assume that a company or individual importing from a foreign supplier would need to buy foreign currency funds by taking a loan from the bank. Therefore, the loan amount that the importer takes gets calculated as follows: 

Domestic Loan (Dl) = Fd × Spot Rate

However, the company would have to bear the total liability on exposure for the period as given by:

Final Domestic Value = Dl + (1+rdb) ^n here, 

• rdb = domestic borrowing rate for the tenure, and 
• n = number of periods during the period of exposure. 

Finally, the company gets its exchange rate fixed by hedging as below:

Effective Exchange Rate = Final Domestic Value/ Foreign Payment

Let us use a couple of examples to understand the topic more clearly.

Example #1

Let us assume that a company uses domestic currency in the dollar and foreign currency in the pound. It has made a deal with a supplier regarding a product for which it has to pay 100000 pounds to the supplier in 1 year. The foreign exchange dollar and pound exchange rates have been quite volatile. As a result, the company wishes to fix its payment in the pound.

The dollar and pound have an annual interest rate of 9% and 10%, respectively. Three units of dollars equal 1 unit pound has been the spot exchange rate. Let us create the hedging utilizing the money market, ignoring lending & borrowing rates differences plus the difference between quotes of bid and offer an exchange as follows:

• Foreign currency payment = 100000
• Number of Periods = n = 1
• Foreign Deposit = 100,000/ (1+10%) ^1 approx.= 90,909
• Domestic Loan = 90,909 * 3
• Final Domestic Value = 272,727 * (1+ 8%) ^1 approx.= 294,545

As per the money market hedge calculator formula,

Effective Exchange Rate = 294,545/ 100,000 approx = 2.945

Example #2

Let us assume that a company uses domestic currency in the dollar and foreign currency in the pound. It has to receive a sum of 20,000 pounds from a customer within six months. The foreign exchange dollar and pound exchange rates have been quite volatile. As a result, the company wishes to fix its payment in the pound. The dollar and pound have an annual interest rate of 9% and 10%, respectively.

Three units of dollars equal 1 unit pound has been the spot exchange rate. Let us create the hedging utilizing the money market, ignoring lending & borrowing rates differences plus the difference between quotes of bid and offer an exchange as follows:

Here one would be calculating the hedging utilizing the money market for Foreign Currency receipt:

• Number of Periods= n = 6/12 = 0.5
• Foreign Loan = 20,000/ (1+10%) ^0.5 approx.= 19,069
• Domestic Deposit = 19,069* 3 approx. = 57,207
• Final Domestic Value = 57,207 *(1+8%) ^0.5 approx. =59,451
• Effective Exchange Rate = 59,451/ 20,000 approx. =2.973

Let us go through the below table to understand the Advantages & Disadvantages of hedging the money market:

Let us discuss some important differences between Money Market Hedge & Forward Hedge:

This article has been a guide to what is Money Market Hedge. We explain the topic with its examples, advantages, disadvantages, and comparison with forward hedge. You may also find some useful articles here -

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