Money Market Hedge: Overview

Money Market Hedge is a way of reducing transaction or accounting risk in foreign exchange exposure by using foreign currency. It entails a contract and a source of finances to carry it out. The contract in this case is a lending agreement.

The money market hedge is achieved by borrowing in one currency and exchanging the proceeds for another currency. Money market hedge is covered if funds to execute the contract, that is, to repay the loan, are created by business operations. Alternatively, when the loan matures, monies to repay the loan can be obtained in the foreign exchange spot market. The money market hedge is exposed or opens in this case.

Forward Exchange Rates

Let’s start by going over some fundamental principles in forward exchange rates, as understanding the complexities of the money market hedging is crucial.

The spot exchange rate is simply adjusted for interest rate differentials to get a future exchange rate. The “Covered Interest Rate Parity” principle states that forward exchange prices should take into account the difference in interest rates between the currency pair’s underlying countries; otherwise, an arbitrage opportunity would exist.

Assume that US banks offer a one-year interest rate of 1.5 percent on US currency (USD) deposits and 2.5 percent on Canadian dollar (CAD) deposits. Despite the fact that U.S. investors may be enticed to convert their money into Canadian dollars and deposit it in CAD accounts because of the higher deposit rates, they are clearly exposed to currency risk. Covered interest rate parity dictates that the cost of hedging this currency risk in the future market by buying US dollars one year ahead would be equivalent to the 1 percent difference in rates between the US and Canada.

We may take this example a step further and determine the currency pair’s one-year forward rate. If the current exchange rate (spot rate) is US$1 = C$1.10, then US$1 placed on deposit at 1.5 percent should be comparable to C$1.10 at 2.5 percent after one year based on covered interest rate parity. As a result, it would seem as:

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

As a result, the one-year forward rate is:

C$1.110837 = US$1.1275 x 1.015 = C$1.110837

It’s worth noting that the currency with the lower interest rate always trades at a premium to the currency with the higher rate. In this scenario, the US dollar (the lower interest rate currency) trades at a forward premium to the Canadian dollar (the higher interest rate currency), meaning that each US dollar will fetch more Canadian dollars a year from now (1.110837 to be exact) than it does today (at 1.10).

Hedge In The Money Market

As the examples in the next section show, the money market hedge works similarly to a forward exchange, but with a few differences.

Foreign exchange risk can arise as a result of transaction exposure (i.e., projected foreign currency receivables or payments) or translation exposure (i.e., assets or liabilities denominated in a foreign currency). Large enterprises face a significantly greater risk of translation exposure than small businesses and retail investors. Although the money market hedge is not the best technique to mitigate translation risk because it is more difficult to set up than an outright forward or option, it can be useful for mitigating transaction risk.

If a foreign currency receivable is expected after a set length of time and currency risk is to be hedged through the money market, the following actions are required:

• Borrow the foreign currency in an amount that equals the receivable’s current value. What is the significance of the present value? Because the amount of the receivable plus the interest on the foreign currency loan should be exactly identical.

• Convert the foreign currency to the local currency using the spot rate.

• Place the native currency in a savings account at the current interest rate.

• Repay the foreign currency loan (from step 1) plus interest when the foreign currency receivable arrives.

Similarly, if a foreign currency payment is required after a set length of time, the processes to hedge currency risk via the money market are as follows:

• Borrow the local currency in an amount equal to the payment’s current value.

• Convert the local currency to the foreign currency at the current exchange rate.

• Put this sum of foreign currency on deposit.

• Make the payout when the foreign currency deposit expires.

Even if the firm developing a money market hedge already has the funds listed in step 1 and does not need to borrow them, there is an opportunity cost associated with employing these assets. The money market hedge accounts for this cost, allowing for an apples-to-apples comparison with forwarding rates, which, as previously stated, are based on interest rate differentials.

Money Market Hedge Examples In Practice

Consider a small Canadian business that has sold items to a customer in the United States and expects to earn $50,000 in a year. The current exchange rate of US$1 = C$1.10 is favorable to the Canadian CEO, and he would like to lock it in because he believes the Canadian dollar will appreciate over the next year (resulting in fewer Canadian dollars for the US dollar export revenues when received in a year’s time). The Canadian corporation can borrow US dollars for a year at 1.75 percent interest and receive 2.5 percent interest on Canadian-dollar deposits.

The Canadian dollar is the domestic currency, while the US dollar is the foreign currency, from the standpoint of the Canadian corporation. The money market hedge is put up as follows.

• The Canadian corporation takes out a loan for the present value of the US currency receivable (i.e. US$50,000 discounted at a 1.75 percent US$ borrowing rate) = US$50,000 / (1.0175) = US$49,140.05. The loan amount, including interest at 1.75 percent, would be exactly US$50,000 after one year.

• The value of US$49,104.15 is converted into Canadian dollars at a rate of 1.10, resulting in a total of C$54,054.05.

• The Canadian dollar sum is deposited at a rate of 2.5 percent, resulting in a maturity amount of C$54,054.05 x (1.025) = C$55,405.41.

• When the export money arrives, the Canadian firm utilizes it to settle the $50,000 US dollar debt. It effectively locked in a one-year forward rate = C$55,405.41 / US$50,000 or US$1 = C$1.108108 because it received C$55,405.41 for this US dollar amount.

It’s worth noting that the corporation might have gotten the same result if it had employed a forward rate. The forward rate would have been determined as follows, as shown in the previous section:

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

Why did the Canadian firm opt for a money market hedge over a straightforward contract? The company may be too small to receive a forward currency facility from its banker, or it may have been unable to obtain a competitive forward rate and instead chose to create a money market hedge.

Example 2: Assume you live in the United States and plan to take your family to Europe for a long-awaited vacation in six months. You estimate that the vacation will cost around EUR 10,000, and you want to pay for it with a performance bonus that you expect in six months. The current EUR spot rate is 1.35, but you’re worried that in six months, the euro will appreciate to 1.40 or even higher, increasing the cost of your vacation by around $500 or 4%.

As a result, you decide to build a money market hedge, which means you can borrow U.S. dollars (your home currency) for six months at an annual rate of 1.75 percent and earn interest on six-month EUR deposits at an annual rate of 1.00 percent. This is how it would appear:

• Borrow USD in an amount equal to the payment’s present value, or EUR 9,950.25 (i.e. EUR 10,000 / [1 + (0.01/2]). It’s worth noting that we divide 1% by 2 to represent half a year, or six months, as the borrowing time. This equates to a loan amount of US$13,432.84 at the current spot rate of 1.35.

• Convert this USD sum to euros at the current spot rate of 1.35, which is EUR 9,950.25 (step 1).

• Place EUR 9,950.25 on deposit for six months at a 1% yearly rate. When the deposit matures in six months, just in time for your holiday, you’ll get exactly EUR 10,000.

• After six months, the total amount owing on the US$ loan, including interest (1.75 percent annual rate for six months), is US$13,550.37. All you have to do now is hope for at least that much in performance bonuses to return the loan.

You’ve effectively locked in a six-month forward rate of 1.355037 (i.e., USD 13,550.37 / EUR 10,000) by employing the money market hedging. It’s worth noting that you could have gotten the same result by using a currency forward, which would be computed 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.

Hedge Fund Applications In The Money Market

• For currencies where forward contracts are not commonly available, such as exotic currencies or those that are not widely traded, the money market hedge can be successful.

• As previously stated, this hedging approach is also appropriate for a small business that does not have access to the currency forward market.

• Money market hedges are particularly well suited to smaller sums of money when a currency hedge is required but futures or currency options are not an option.

Money Market Hedge’s Advantages And Disadvantages

• Like a forward contract, a money market hedge fixes the exchange rate for a future transaction. Depending on currency movements until the transaction date, this can be advantageous or disadvantageous. For example, if the euro was trading at 1.40 at vacation time (since you had locked in a rate of 1.3550), you would feel smart, but less so if it had plummeted to 1.30.

• Money market hedges can be tailored to exact amounts and dates. Although currency forwards offers the same level of flexibility, the forward market is not available to everyone.

• Because it is a step-by-step deconstruction of conventional currency forwards, the money market hedge is more sophisticated than regular currency forwards. It may thus be suitable for hedging occasional or one-off transactions, but it may be too burdensome for frequent transactions due to the multiple procedures involved.

• Implementing a money market hedge may also present logistical challenges. Obtaining a large loan and putting foreign currencies on deposit, for example, is time-consuming, and the actual rates used in the money market hedging may differ significantly from the wholesale rates used to price currency forwards.

Final Thoughts

As a technique of mitigating currency risk, the money market hedge is a viable alternative to traditional hedging tools such as forwards and futures. It’s very simple to set up, as one of the only prerequisites is that you have bank accounts in many currencies. However, because of the number of steps involved, this hedging approach is more complicated, and its efficiency may be hampered by logistical constraints as well as actual interest rates that differ from institutional rates. As a result, the money market hedge may be best suited for one-time or occasional trades.

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