The money market is a financial market in which highly liquid instruments such as treasury bills, commercial papers and bankers’ acceptances are traded. These markets usually sell short-term instruments. A money market hedge, as the name implies, is a hedging technique used to tame the forex risk and uses the money market for the purpose. Forex risk can also be hedged using other techniques such as futures and currency forwards. It may also be noted that the money market is not the most cost effective option to hedge forex risk for large investors such as corporations or other big players.
For a small business or a retail investor that is looking to hedge forex risk with not very big amounts such as the ones that warrant getting into forwards contracts or the futures market, the money market is a good method that can be used as a protection from currency market fluctuations.
Forwards Exchange Rates
A basic knowledge about forward exchange rates is essential to understand hedging forex risk using the money market. The forward exchange rate is simply the benchmark rate adjusted for the difference in interest rates of the countries whose currencies are being traded in the pair. This is to be done in principle to avoid an arbitrage opportunity.
As an example, If US banks offer an interest rate of 1.5% per annum on USD deposits and Canadian banks offer an interest rate of 2.5% per annum on Canadian dollar deposits, it is natural that US depositors would be tempted to place their funds as Canadian bank deposits that would fetch higher interest. However, they face a currency risk and to hedge this risk in the forward market while buying USD one year into the future, the interest rate parity principle necessitates that the hedging cost would be equal to the 1% difference between the Canada and US interest rates.
In such a case, the currency with the lower interest rate would trade at a forward premium with the currency that is at a higher interest rate. This is true for any currency pair. That is, every USD would fetch a greater number of Canadian dollars in a year’s time from now. The rate is compared with the current spot rate of the USD.
Money Market Hedge
The money market hedge works in a very similar manner to the forward exchange but for a few minor differences. Forex risks can happen mainly due to two reasons: 1) firstly, the risk can be because of money expected (receivables) that are due in a foreign currency or payments that are to be done in a foreign currency or 2) secondly, because assets are fixed using a foreign currency. The second reason is more of a concern for the larger investors. In such a case the money market route may not be the most appropriate way to hedge forex risk. However this method is more suited to tackle the first type of transaction exposure situation.
If a certain amount of foreign currency is expected to be received or paid after a fixed amount of time and if the forex risk has to be hedged using the money market, the following steps may be followed:
In the case of foreign currency receivables, the first step should be to borrow the foreign currency for a value that is equivalent to the present value of the receivable amount. This is done because the current loan plus the interest charged would be equal to the amount receivable. This is then converted to the domestic currency at the existing exchange rate. Deposit the domestic currency amount at the prevailing interest rate. When the receivable comes in at the prescribed date, the foreign currency loan can be paid off using the amount that has been deposited.
In the second case, when a payment has to be made using a foreign currency on a specified date in the future, the risk can be hedged as follows:
First of all, borrow a domestic currency amount that is equal to the present value of the payment to be made. The next step is to convert it to the foreign currency at the current exchange rate. This should then be placed in a deposit and make the payment when this deposit amount reaches maturity.
Applications of Money Market Hedging
Money market hedging can be used in cases where the currencies traded are exotic and which are not popularly traded. For such currencies forward contracts may not be easily available.
Money market hedging can be used effectively for those small businesses which do not have access to the currency forward market.
This hedging technique can be adopted for hedging smaller amounts and when the trader is not ready to use currency options or futures.
Advantages and Disadvantages
The money market hedging technique works by fixing the exchange rate for a future transaction (at a specific date). This may work favorably or otherwise and depends on the fluctuations in the value of the currency until the said date.
The money market hedge can be made to work to specific dates and precise amounts. Though currency forwards also offer the same advantages, they are not easily accessible to everyone.
The money market hedge is more complicated than currency forwards and is more comfortable when executed occasionally. It may be too cumbersome when done frequently because of the numerous steps that are involved.
Logical constraints may be present when using money market hedging. It may be difficult to make a deposit using a foreign currency or for arranging loans for the required amounts. The actual rates used for money market hedging may be very different from the wholesale rates used in currency forwards.
Money market hedging is an effective method to mitigate forex risk when other methods such as futures or forwards are inaccessible or cannot be used. It is easy to set up, especially if the trader has bank accounts in two different currencies. As already seen, the method of money market hedging is best suited for occasional forex risk management.