Money Market Hedges

Money Market Hedges

Money market hedges are a method used for hedging foreign exchange risk

Basic idea

The money markets are markets for wholesale (large-scale) lending and borrowing, or trading in short-term financial instruments. Many companies are able to borrow or deposit funds through their bank in the money markets.

Instead of hedging a currency exposure with a forward contract, a company could use the money markets to lend or borrow, and achieve a similar result.

The basic idea is to avoid future exchange rate uncertainty by making the exchange at today's spot rate instead. This is achieved by depositing/borrowing the foreign currency until the actual commercial transaction cash flows occur.

Since forward exchange rates are derived from spot rates and money market interest rates, the end result from hedging should be roughly the same by either method.

Setting up the hedge

In effect a foreign currency asset is set up to match against a future liability (and vice-versa).

If you are hedging a future payment:

  • buy the present value of the foreign currency amount today at the spot rate
  • the foreign currency purchased is placed on deposit and accrues interest until the transaction date.
  • the deposit is then used to make the foreign currency payment.

If you are hedging a receipt:

  • borrow the present value of the foreign currency amount today
  • the foreign loan accrues interest until the transaction date
  • the loan is then repaid with the foreign currency receipt

Advantages and disadvantages

Forward exchange contracts are used extensively for hedging currency transaction exposures.

Advantages include:

  • fixes the future rate, thus eliminating downside risk exposure
  • flexibility with regard to the amount to be covered
  • money market hedges may be feasible as a way of hedging for currencies where forward contracts are not available. 

Disadvantages include:

  • more complicated to organise than a forward contract 
  • Fixes the future rate - no opportunity to benefit from favourable movements in exchange rates.  

Further comments

Interest rate parity implies that a money market hedge should give the same result as a forward contract.

Created at 9/12/2012 10:37 AM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London
Last modified at 11/1/2016 1:02 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

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Forward contracts;option-dated forwards;synthetic forwards

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