A money market hedge is a financial strategy used by businesses to protect against foreign exchange risk. It secures the domestic currency value of a future foreign currency transaction by leveraging a mix of borrowing, investing, and spot currency exchange.
Imagine a UK-based business expects to receive U.S. dollars from export sales. To eliminate currency risk, it can implement a money market hedge by following these steps:
Borrow U.S. dollars today at the company’s prevailing fixed dollar interest rate, planning to repay the loan when the dollar revenue arrives.
Convert the borrowed dollars into British pounds immediately using the current spot exchange rate.
Invest the pounds in a fixed-rate sterling deposit that matures on the same date as the expected dollar payment.
This process creates a “synthetic” forward exchange contract, locking in an effective exchange rate based on the interest rate gap between the two currencies. It’s a strategic tool that helps manage foreign currency exposure with more predictability.
ABC Co, a UK-based manufacturing company, exports products to the United States and expects to receive $2 million in three months. If ABC Co had a matching $2 million liability payable in three months, the foreign currency risk would be neutralized — the dollar inflow would offset the dollar outflow.
However, without a corresponding liability, ABC Co can create a synthetic hedge by borrowing U.S. dollars now and repaying the loan with the future dollar receipt. Here's how this money market hedge works:
To find out how much to borrow today, we need to account for U.S. dollar interest rates. Suppose the 3-month dollar interest rate is quoted as 0.54% (deposit rate) and 0.66% (borrowing rate) annually.
Note: Interest rates are quoted on an annualized basis, so they must be adjusted for the actual loan term—in this case, three months.
Let X be the amount of dollars to borrow now. With a borrowing rate of 0.66% per annum:
X×(1+0.66%×3/12)=2,000,000
X=2,000,000/(1+0.66%×3/12)
Solving this:
Therefore, X = $1,996,705
So, ABC Co should borrow $1,996,705 today.
Converting USD to GBP:
This can be exchanged for £s now, at the current spot rate, say at $ per £, 1.4701 = £1,358,210.
This amount in pounds is now fixed, protecting the company from future currency fluctuations, regardless of how the exchange rate moves in the next three months.
A money market hedge enables companies like ABC Co to lock in the GBP value of future dollar receipts by creating a matched liability in the foreign currency. It’s a practical and effective way to manage foreign exchange risk using interest rate differentials and spot market transactions.
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