The money market hedge is a procedure for risk management by connecting the value of a foreign currency to the domestic currency that gets used by a certain company. This method gets used to reduce the risk when transacting with a foreign business entity.
The name money market hedge is a product of the deposit process in a financial market with large liquid, in the money market, but also short-term instruments that incorporate bankers’ acceptances, treasury bills, and commercial paper that gets traded.
Managing foreign exchange risk is not limited to a single method, there are several options such as futures and currency forwards, which can be a more appropriate option for big institutions and corporations to protect against such risk.
Although for businesses and retail investors that are trying to hedge currency risk, the money market hedge is an option to safeguard against fluctuations in a currency, without having to create a forward contract or implement the futures market, or enter into a forward contract.
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- The Money Market
- Money Market Hedge Explained
- Forward Exchange Rates
- The Money Market Hedge
- Practical Examples of Money Market Hedge
- Payment of Foreign Currency
- Inflexibility in Foreign Exchange
- Money Market Hedge Applications
- Advantages and Disadvantages of Money Market Hedge
- Money Market Hedge vs. Forward Contract
The Money Market
The domestic money market is stable if the supply of money is the same as the demand. Because the money supply is something that gets regulated by the government or to be more accurate by the central banks.
But on the other hand, the demand for money is something that is in the hands of private agents. This is because these agents require money to facilitate daily activities, and this in turn has a rising effect on the accumulation of earnings of the economy.
Yet, money in the pocket doesn’t generate interest, something that is an option if they are on a bank account.
Basically, the interest rate is the expense accumulated for holding money. The demand for money is the positive element of earnings, while it is a negative element of the interest rate.
Money Market Hedge Explained
The money market hedge enables a company to connect the worth of the partner’s currency to its domestic currency before a planned transaction.
This provides confidence concerning the expense of future transactions and guarantees that the company will be able to pay the price that it plans on paying.
If the money market hedge doesn’t exist, the company would get exposed to the fluctuation of the exchange rate, and significant changes in the price of the transaction. Because of the fluctuations in exchange rates, the transaction can get more expensive or it can be cheaper.
This is the advantage of the money market hedge, which provides flexibility concerning the t covered amount. A company has the option to hedge only half of a transaction value.
There is another benefit from using a money market hedge, and that is for exotic currencies hedging. In cases with these types of currencies, there are limited alternative methods for managing the risk that comes with an exchange rate.
Forward Exchange Rates
To understand the complexities of the money market hedge, we must look at some elementary concepts about the forward exchange rates.
The forward exchange rate is the benchmark rate modified to the interest rate particularities. The principle is that forward exchange rates must absorb the diversity in interest rates amid the primary countries of the currency pair, contrarily there will be an arbitrage opportunity.
For example, let’s speculate that the Australian banks offer an interest rate for a dollar (AUD) deposit of one percent, while New Zealand banks offer an interest rate of two percent on an AUD- NZD deposit.
Some Australian investors may think it a good idea to convert their funds into New Zealand dollars because of the more lucrative deposit rates, but simultaneously they will encounter the currency risk.
For the investors, it will be a good idea to hedge the risk in the forward market by purchasing Australian dollars one year forward. Covered interest rate consistency imposes the expense of such hedging that will be the same as the one percent variation among the Australian and New Zealand rates.
The Money Market Hedge
The working principles of the forward exchange and the money market hedge are very similar, although there are several differences, something that we will illustrate.
Foreign currency risk can emerge because of the transaction exposure or the translation exposure, which happens because the assets denomination is in a foreign currency. For large corporations, the translation exposure is a larger problem than it is for retail investors and small businesses.
However, the money market hedge is not the best option to hedge against transaction exposure because it’s complex to set up, rather than implementing an unequivocal option or forward option. Yet it is efficient for hedging foreign currency transaction exposure.
If a foreign currency receivable gets anticipated following a detailed period, and the currency risk is applicable to be hedged through the money market, this can entail the ensuing steps:
- The spot exchange rate should get used to converting the foreign currency into the currency of the domestic company.
- Obtain the foreign currency in a quantity comparable to the present value of the receivable. The current value gets used because the loan for the foreign currency plus the interest has to be precisely the same as the quantity of the receivable.
- The loan on the foreign currency should be repaid with interest after the foreign currency receivable arrives.
- Make the domestic currency on deposit at the predominant interest rate.
When a foreign currency payment needs to get performed following a defined period the next steps should be undertaken to hedge currency risk in the money market:
- The domestic currency should get converted into a foreign currency at the spot rate.
- Obtain the domestic currency in a quantity similar to the current payment value.
- Perform the payment following the maturation of the foreign currency deposit.
- Make this foreign currency quantity on deposit.
Take into consideration that a corporation or institution that is formulating a money market hedge, can have at its disposal the funds in the first step, and may have no need to loan them. This results in an opportunity cost for implementing the funds.
The money market hedge accepts the expense into deliberation allowing for a direct comparison with forwarding rates that are created on differentials on an interest rate.
Practical Examples of Money Market Hedge
Let’s take a look at a couple of examples of money market hedges.
For our first example, we can assume that you are living in Australia and are making arrangements to take your wife on a vacation in Great Britain. The calculations for all the expenses relating to the trip come up to 5000 AUD, and you plan to cover the vacation with the bonus you are going to get in three months.
The present GBP spot rate is 1.40, but you worry that the pound can rise in value to 1.50 to AUD in the next three months, this, in turn, will increase the bill for the vacation by about 5%.
Because of this, you begin formulating a money market hedge which means acquiring AUD for three months at a yearly rate of 1.75%, and getting interested at the yearly rate of 1.00% on three-month GBP deposits. This would look something like this:
- Obtain by renting the AUD in a quantity comparable to the current payment value or GBP.
- Convert the AUD amount into pounds at the spot rate of 1.40.
- Place an AUD 4,950 on deposit at the one percent yearly rate for three months. This will generate precisely GBP 5000 after the maturation of the deposit in five months.
- Repay the complete amount of the GBP loan with the interest after five months.
With the money market hedge, you can maintain a five-month forward rate. But the identical outcome could have been done with a currency forward.
For the second example, let’s assume that a midsize New Zealand company plans to exported products to a German importer and project to earn Euro 100,000 in one year.
The managing director of the New Zealand company sees the present exchange rate of Euro 1 = NZD$1.10 as beneficial and prefers to lock it because he expects the Euro can rise in value over the year.
This will generate a lower return in Euros for the New Zealand dollars. The New Zealand company can obtain via loan Euro at 1.75% for one year and receive 2.5% per year for Euro-New Zealand dollar deposits.
From the New Zealand company’s perspective, the domestic currency is the Euro used in Germany and the foreign currency is the NZD. This is the method for arranging the money market hedge in this situation.
- The New Zealand company acquires the current value of the Euro receivable at the borrowing rate of 1.75%. Following the year, the borrowed sum plus the interest at 1.75% would be exactly Euro 100,000.
- The amount of Euros gets converted into NZD at the spot rate of 1.10.
- The NZD amount gets placed on deposit at 2.5%.
- After the export payment gets received, the New Zealand company will use it to repay the loan.
With a forward rate, the company would have accomplished the same result. And this brings up the point of why would the New Zealand company use the money market hedge and not the direct forward contract?
There are several factors, such as the company being too small to get a forward currency facility, or the forward rate was not competitive, and choosing the money market hedge.
Payment of Foreign Currency
When an exporting company has to pay foreign currency in the future to an importing business it faces a risk of a rise in the worth of the foreign currency counter the home currency value.
With a hedge through the money market, investors can be depositing a certain amount of a foreign currency in a period between the present and the payment date.
The principle and the interest following the deposit period’s conclusion have to be the same as the sum that has to get paid so that when the deposit period ends. With the foreign deposit is the current worth of the foreign payment.
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Inflexibility in Foreign Exchange
The regular foreign exchange hedges are very inflexible in several aspects. Trades of futures in organized markets are liquid, yet there is no option for adaptability among the parties.
Futures have legal conditions for investors to convey and acquire payment at a prearranged price and date. The holder has the discretionary right to use the options.
Money Market Hedge Applications
The technique is appropriate for a small business in need of foreign currency transactions that are not able to access the currency forward market. It can get used for exotic currencies where forward contracts are available frequently or are not traded extensively.
The money market hedge is particularly effective for smaller capital amounts in a situation when there is a need for a currency hedge, but there is no desire to implement futures or currency options.
Advantages and Disadvantages of Money Market Hedge
The point of the money market hedge is to fix the exchange rate for any transaction in the future. Simultaneously it can be positive and negative concerning fluctuation in the currency until the transaction date.
The money market hedge can get personalized to accurate dates and amounts. But this option to tailor different segments is present in currency forwards. The only difference is that the forward market hedge is not consonantly available for everyone.
Unlike currency forwards, the money market hedge is more complex. Because of this, it is more appropriate for hedging casual or singular transactions. However, because of the specific stages that come with the technique, it’s too demanding of a process for regular transactions.
At the same time incorporating a money market hedge can have several limitations. For one handling a large foreign currency borrowing rate and making foreign currencies on the current rates in the money market hedge can fluctuate by a large measure on the entire rates that get implemented in a price currency forwards.
Money Market Hedge vs. Forward Contract
If you are a U.S.-based company and are not able or willing to implement a money market hedge, they can turn to a foreign exchange swap, a forward contract, or take the risk and pay the exchange rate at a future time date.
Companies that regularly undertake a significant number of transactions can decide to stay away from a money market hedge technique because it is complex and focus on a forward contract as a more suitable option for their business activities.
Money market hedges introduce concepts that get implemented to lock in a given variable corresponding to foreign exchange. Although they attempt to control volatility, every financial move will bring risks and limitations.
The disadvantages of hedging techniques and inflexibility, complexity, and disclosure practices, the expense of using hedging strategies, and the failure to engage in opportune trends in financial markets can negatively affect the outcome.
The money market hedge offers a great substitute for reducing risk over other options for hedging, and this refers to futures and forwards and futures. It is not complicated to implement, the only condition is to own bank accounts for a few various currencies.
Yet there are also a few limitations such as the difficulty in implementing it and the numerous stages that have to be used, but also the limitations, and the interest rates that are not the same as standard institutional rates. Because of this, the money market hedge can be appropriate for infrequent or one-time transactions.
How do You Calculate Money Market Hedging?
The money market hedge can get implemented by purchasing the present worth of the foreign currency transaction at the spot rate. For example, in the forex market, an investor gets a foreign currency loan on a Canadian dollar. Putting the foreign currency bought on deposit with a money market with a certain interest until the payment is due, and implementing the deposit to take care of foreign currency payment.
What Is to Hedge in the Forward Market?
The hedge in the forward market is used to minimize currency exposure. The forward market is typically engaged in bigger contracts that are performed by institutional and corporate entities.
Is Currency Hedging Worth the Risk?
Currency hedging is a good option if investing in bonds, but is not recommended for equities. The currency risk can have a big influence on the complete risk exposure on the portfolio.