Money Market Hedge

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. The money market hedge would be executed by: Buying the current value of the foreign currency transaction amount at the spot rate. Placing the foreign currency purchased on deposit with a money market and receiving interest until payment is made. The company could 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 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. Therefore, a money market hedge can help a domestic company reduce its exchange rate or currency risk when conducting business transactions with a foreign company.

A money market hedge is a tool for managing currency or exchange-rate risk.

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, a money 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.

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.

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.

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 regard to 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 months and must pay for the supplies in euros rather than dollars. The company could 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:

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 a money market hedge is typically more complicated to organize than a forward contract.

Related terms:

Currency Risk

Currency risk is a form of risk that arises from the change in price of one currency against another. Investors or companies that have assets or business operations across national borders are exposed to currency risk that may create unpredictable profits and losses. read more

Derivative

A derivative is a securitized contract whose value is dependent upon one or more underlying assets. Its price is determined by fluctuations in that asset. read more

Dual Currency Swap

A dual currency swap is a type of derivative that allows investors to hedge the currency risks associated with dual currency bonds. read more

Euro

The European Economic and Monetary Union is comprised of 27 member nations, 19 of whom have adopted the euro (EUR) as their official currency. read more

Exchange Rate

An exchange rate is the value of a nation’s currency in terms of the currency of another nation or economic zone. read more

Exotic Currency

Exotic currencies are currencies that are thinly traded in foreign exchange markets and are not widely used in global financial transactions. read more

Foreign Currency Effects

Foreign currency effects are gains or losses on foreign investments due to changes in the relative value of assets denominated in another currency. read more

Forward Booking

Forward booking is the process of entering into a contract with a booking company, or risk agent, to lock in a specific price for a future date. read more

Forward Contract

A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. read more

Hedging Transaction

A hedging transaction is a position that an investor enters to offset the risks related to another position they hold.  read more