Companies that do business internationally run the risk of losing money due to unpredictable changes in the values of their home currency compared to those of the businesses they're dealing with abroad. One key strategy for alleviating currency market risk is the money market hedge.

The money market hedge relies on the 🧸financial market for highly liquid short-term instruments like Treasury bills, bankers’ acceptan🍎ces, and commercial paper.

Other avenues may be more efficient for large corporations and institutions. For retail investors and small businesses, the money markeꦕt hedge may be an easier way to protect against currency fluctuations.

Understanding the Money Market Hedge

Knowing the basics of forward exchange rates is essential to unders🎶tanding the intricacies of the money market hedge.

A forward exchange rate is the spot exchange (or benchmark) rate adjusted for 澳洲幸运5官方开奖结果体彩网:interest rate differentials. The principle of 澳洲幸运5官方开奖结果体彩网:covered interest rate parity holds that forward exchange rates should incorporate the difference in interest rates💃 between the underlying countries of the currency pair, or an arbitrage opportunity would exist. 

How Forward Exchange Rates Work

For example, say U.S. banks offer a one-year interest rate on U.S. dollar (USD) deposits of 1.5%, and Canadian banks offer an interest rate of 2.5% on Canadian-dollar (CAD) deposits. U.S. investors might be tempted to convert their money into Canadian dollars and deposit these funds in higher-yielding CAD dep𝓀osits.

However, that exposes them to currency risk. If they hedge this currency risk in the 澳洲幸运5官方开奖结果体彩网:forward market by buying U.S. dollars one year forward, covered interest rate parity stipulates that the c🎃ost of such hedging would be equal to the 1% difference in rates between the U.S. and Canada.

We can take this example a step further to calculate the one-year forward rate for this currency pair. If the current 澳洲幸运5官方开奖结果体彩网:exchange rate (the spot rate) is US$1 = C$1.10, then based on covered interest rate parity, U𒈔S$1 placed on deposit at 1.5% should be equivalent to C$1.10 at 2.5% after one year. Thus, it would be showꦺn as:

US$1 (1 + 0.015) = C$1.10 (1 + 0.025), or US$1.015 = C$1.1275

And, the one-year forward rate therefore is:

US$1= C$1.1275 ÷ 1.015 = C$1.110837

Note that the currency with the lower interest rate always trades at a 澳洲幸运5官方开奖结果体彩网:forward premium to the currency with the higher interest rate.

In this case, the U.S. dollar (the lower interest rate currency) trades at a forward premium to the Canadian dollar (the higher interest rate currency), which means that each U.S. dollar fetches more Canadian dollars (1.110837 to be precise) a year from now, compared with the 澳洲幸运5官方开奖结果体彩网:spot rate of 1.10.

The money market hedge works in a similar way but with a few tweaks.

Why Use a Money Market Hedge?

The money market hedge is effective in alleviating 澳洲幸运5官方开奖结果体彩网:transaction exposure. The prices that go into a contract are quoted in the foreign currency. The time lag betwee🍌n signing the contract and delivering the goods to a foreign customer, or receiving them from a foreign seller, creates transaction exposure.

Completin🧸g a money market ꧅hedge requires the following steps:

1. Borrow the foreign currency in an amount equivalent to the 澳洲幸运5官方开奖结果体彩网:present value of the receivable. Why the present value? Because the foreign currency loan plus the interest on it should be exactly equal to the amount of the receivable.
2. Convert the foreign currency into domestic currency at the spot exchange rate.
3. Place the domestic currency on deposit at the prevailing interest rate.
4. When the foreign currency receivable comes in, repay the foreign currency loan plus interest.

Similarly, if a foreign currency payment haไs to be made at a defined time, the following steps have to be taken to hedge currency risk via the money market:

1. Borrow the domestic currency in an amount equivalent to the present value of the payment.
2. Convert the domestic currency into the foreign currency at the spot rate.
3. Place this foreign currency amount on deposit.
4. When the foreign currency deposit matures, make the payment.

The company that is engaged in a money market hedge may have free cash to buy rather than borrow the domestic currency. However, the money market hedge takes into account the 澳洲幸运5官方开奖结果体彩网:opportunity cost involved in borrowing the money. That allows an appl🉐es-to-apples comparison to be made with forwar🍒d rates, which as noted are based on interest rate differentials.

Examples of Money Market Hedges

Example 1: Consider a small Canadian company that has exported goods to a U.S. customer and expects to receive US$50,000 in one year. The Canadian CEO views the current exchange rate of US$1 = C$1.10 as favorable and would like to lock it in since they think that the Canadian dollar may appreciate over the year ahead, which would result in fewer Canadian dollars for the export proceeds when they are paid a year later.

The Canadian company can borrow US$ at 1.75% for one year and can receiওve 2.5% per annum for Canadian-dollar deposits.

From the perspective of the Canadian company, the domestic currency is the Canadian dollar and the foreign currency is the US dollar. Here’s how the money market h🅺edge is set up.

1. The Canadian company borrows the present value of the U.S. dollar receivable (i.e. US$50,000 discounted at the US$ borrowing rate of 1.75%) = US$50,000 / (1.0175) = US$49,140.05. After one year, the loan amount including interest at 1.75% would be exactly US$50,000.
2. The amount of US$49,104.15 is converted into Canadian dollars at the spot rate of 1.10, to get C$54,054.05.
3. The Canadian dollar amount is placed on deposit at 2.5% so the maturity amount (after one year) = C$54,054.05 x (1.025) = C$55,405.41.
4. When the export payment is received, the Canadian company uses it to repay the U.S. dollar loan of US$50,000. Since it received C$55,405.41 for this U.S. dollar amount, it effectively 澳洲幸运5官方开奖结果体彩网:locked in a one-year forward rate = C$55,405.41 / US$50,000 or US$1 = C$1.108108

Note that the same result could have been achieved if the company had used a forward rate. As demonstrated in the previous section, the forward rate 🐻would have been calculated as:

US$1 (1 + 0.0175) = C$1.10 (1 + 0.025); or US$1.0175 = C$1.1275; or US$1 = C$1.108108

Why would the Canadian company use the money market hedge rather than a forward contract? It could be that the company is too small to obtain a forward currency facility from its banker. Or, perhaps it did not get a competitive forward r🐬ate an♒d decided to structure a money market hedge instead.

Example 2: Suppose you live in the U.S. and intend to take your family on a European vacation in six months. You estimate the vacation will cost about EUR 10,000 and plan to foot the bill with a 澳洲幸运5官方开奖结果体彩网:performance bonus that you expect to receive in six months.

The current EUR spot rate is 1.3ཧ5, but you are concerned that the euro could increase to 1.40 to the USD or even highe🌠r in six months, which would raise the cost of your vacation by about US$500 or 4%.

Therefore, you decide to construct a money market hedge, which means you can borrow U.S. dollars (your domestic currency) for six months at an annual rate of 1.75%, and receive interest at an annual rate of 1.00% on six-month EUR deposits. Here's how that would look:

1. Borrow U.S. dollars in an amount equivalent to the present value of the payment, or EUR 9,950.25 (i.e. EUR 10,000 / [1 + (0.01/2]). Note that we divide 1% by 2 to reflect half a year or six months, which is the borrowing period. At the spot rate of 1.35, this works out to a loan amount of US$13,432.84.
2. Convert this USD amount into euros at the spot rate of 1.35, which from step 1 is EUR 9,950.25.
3. Place EUR 9,950.25 on deposit at the 1% 澳洲幸运5官方开奖结果体彩网:annualized rate for six months. This will yield exactly EUR 10,000 when the deposit matures in six months, in time for your vacation.
4. The total amount repayable of the US dollar loan including interest (1.75% annual rate for six months) is US$13,550.37 after six months.

Now all you have to do is hope that you receive a performance bonus of at least t꧅hat amount to repay the loan.

By using the money market hedge, you have effectively locked in a six-month forward rate of 1.355037 (i.e., USD 13,550.37 / EUR 10,000). Note that you could have arrived at the same result if you had used a 澳洲幸运5官方开奖结果体彩网:currency forward, which would have been calculated as:

EUR 1 (1 + (0.01/2)) = USD 1.35 (1 + (0.0175/2)), or EUR 1.005 = USD 1.3618125, or EUR 1 = USD 1.355037.

Money Market Hedge Applications

The money market hedge can be used effectively for currencies where forward contracts are not readily available, such as 澳洲幸运5官方开奖结果体彩网:exotic currencies or those that are not widely traded.

This hedging technique is alsoꦑ suitable for a small business that does not have access to the currency forward market, as noted earlier.

The money market hedge is especially effective for smaller amounts of capital when someone requires a currency hedge but is unwilling to use futures or 澳洲幸运5官方开奖结果体彩网:currency options.

Pros and Cons of Money Market Hedge

The money market hedge, like a forward contract, 澳洲幸运5官方开奖结果体彩网:fixes the exchange rate for a future transaction. This can be good or bad, depending on currency fluctuations until the 澳洲幸运5官方开奖结果体彩网:transaction date.

For instance, in the previous example of fixing the euro rate, you would feel smart if the euro was trading at say 1.40 by vacation time 🌃(since you had locked in a rate of 1.3550), but less so if it had plunged to 1.30.

Th🌠e money market hedge can be customized to precise amounts and dates. Though this degree of customization is also available in currency forwards, the forward market is not readily accessible to everyone.

The money market hedge is more complicated than regular currency forwards since it is a step-by-step deconstruction of the latter. It may be suitable for hedging occasional or one-off transactions, but as it involves several distinct steps it is inconvenient for fr꧃equent transactions. 

There may be logistical constraints in implementin♎g a money market hedge. For instance, arranging for a substantial loan amount and placing foreign currencies on deposit is cumbersome and the actual rates used in the money market hedge may vary significantly from the wholesale rates that are used to price currency forwards.

The Bottom Line

The money market hedge is an effective alternative to other hedging tools such as forwards and futures๊ as a means to mitigate currency risk.

It is 🗹also relatively easy to set up, as one of its only requirements is to have bank accounts in a couple of different currencies.

However, this hedꦛging technique is more difficult due to the number of steps involved. Its effectiveness may be impeded by logis💞tical constraints as well as the difference between actual interest rates and institutional rates.

For these reasons, the mone꧃y market hedge may be best suite🍃d for occasional or one-off transactions.