What Is a Money Market Hedge?
A money market hedge is a technique used to lock in the value of a foreign currency transaction in a company’s domestic currency.Therefore, amoney market hedge can help a domestic company reduce its exchange rate or currency risk when conducting business transactions with a foreign company. It is called a money market hedge because the process involves depositing funds into a money market, which is the financial market of highly liquid and short-term instruments like Treasury bills, bankers’ acceptances, and commercial paper.
Money Market Hedge Explained
The money market hedge allows the domestic company to lock in the value of its partner’s currency (in the domestic company’s currency) in advance of an anticipated transaction. This creates certainty about the cost of future transactions and ensures the domestic company will pay the price that it wants to pay.
Key Takeaways
- A money market hedge is a tool for managing currency or exchange-rate risk.
- It allows a company to lock in an exchange rate ahead of a transaction with a party overseas.
- Money market hedges can offer some flexibility, such as hedging only half of the value of a transaction.
- Money market hedges are typically more complicated than other forms of foreign exchange hedging, such as forward contracts.
Without a money market hedge, a domestic company would be subject to exchange rate fluctuations that could dramatically alter the transaction’s price.While changes in exchange-rate rates could cause the transaction to become less expensive, fluctuations could also make it more expensive and possibly cost-prohibitive.
A money market hedge offers flexibility in regardto the amount covered. For example, a company may only want to hedge half of the value of an upcoming transaction. The money market hedge is also useful for hedging in exotic currencies, such as the South Korean won, where there are few alternate methods for hedging exchange rate risk.
Money Market Hedge Example
Suppose an American company knows that it needs to purchase supplies from a German company in six monthsand mustpay for the supplies in euros rather than dollars.The companycould use a money market hedge to lock in the value of the euro relative to the dollar at the current rate so that, even if the dollar weakens relative to the euro in six months, the U.S. company knows exactly what the transaction cost is going to be in dollars and can budget accordingly. The money market hedge would be executed by:
- Buying the current value of the foreign currency transaction amount at the spot rate.
- Placingthe foreign currency purchased on deposit with a money market and receivinginterest until payment is made.
- Usingthe deposit to make the foreign currency payment.
Money Market Hedge vs. Forward Contract
If a U.S. company cannot or does not want to use a money market hedge, it could use a forward contract,foreign exchange swap, or simply take a chance and pay whatever the exchange rate happens to be in six months. Companies may choose not to use a money market hedge if they perform a large number of transactions because amoney market hedgeistypically more complicated to organizethan a forward contract.
FAQs
A money market hedge is a tool for managing currency or exchange-rate risk. It allows a company to lock in an exchange rate ahead of a transaction with a party overseas. Money market hedges can offer some flexibility, such as hedging only half of the value of a transaction.
What is hedging with an example? ›
Hedging is recognizing the dangers that come with every investment and choosing to be protected from any untoward event that can impact one's finances. One clear example of this is getting car insurance. In the event of a car accident, the insurance policy will shoulder at least part of the repair costs.
What are the three common hedging strategies to reduce market risk? ›
At a high level, there are three hedge strategy types that companies deploy:
- Budget hedge to lock in a budget rate.
- Layering hedge to smooth rate impacts.
- Year-over-year (YoY) hedge to protect the prior year's rates (50% is likely achievable)
If a company is anticipating that it will make a payment in a foreign currency at a future date it can hedge against currency risk by carrying out a money market hedge.
What is an example of a money market company? ›
The institutions that offer money market instruments to the lenders (investors) include commercial banks, corporations, government, non-banking financial institutions, etc. Some of the examples of money market instruments include commercial papers, treasury bills, certificates of deposits, etc.
What is the hedging strategy? ›
Hedging is an advanced risk management strategy that involves buying or selling an investment to potentially help reduce the risk of loss of an existing position.
What is an example of a hedging business? ›
For example, a coffee company depends on a regular, predictable supply of coffee beans. To protect itself against a possible increase in coffee bean prices, the company could enter into a futures contract that would allow it to buy beans at a specific price on a particular date. That contract is a hedge.
What is the basic definition of hedging? ›
The practice by which a business or investor limits risk by taking positions that tend to offset each other.
What are the disadvantages of the money market hedge? ›
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.
How does the money market work? ›
Money market accounts are a type of savings account. They pay interest, but some issuers offer account holders limited rights to occasionally withdraw money or write checks against the account. (Withdrawals are limited by federal regulations. If they are exceeded, the bank promptly converts it to a checking account.)
Participants in the money markets use a variety of derivative instruments for the purposes of trading and hedging. These are primarily interest-rate derivatves. The market in short-term interest-rate derivatives is large and liquid, and the instruments involved are used by both financial institutions and corporates.
How do hedge funds pick stocks? ›
Mutual funds invest mainly in stocks and bonds and seek returns that either replicate or try to beat a benchmark index. Hedge funds may use one or more from among several more complex strategies including short-selling, the use of leverage, and derivatives and seek absolute returns.
Can hedging reduce risk? ›
Hedging to mitigate risks
The primary reason for hedging is risk management: attempting to mitigate the extent of potential losses. Rather than closing an existing trade that could move in an undesirable direction, choosing to hedge (e.g., take the offsetting position in an asset) may mitigate potential losses.
What is a currency hedge in simple terms? ›
In general, currency hedging reduces the increase or decrease in the value of an investment due to changes in the exchange rate. In other words, it aims to even out results.
