What is a money market hedge?
Money market hedging is a technique used to fix the value of a company’s foreign currency transactions in its domestic currency. Therefore, money market hedging helps domestic companies mitigate exchange rate or currency risk when doing business with foreign companies. This is called money market hedging because it involves the process of depositing funds in the money markets. The money market is a financial market for highly liquid money markets such as Treasury bills, banker approvals and commercial papers.
Description of Money Market Hedging
Money market hedging allows a domestic company to fix the value of its partner’s currency (domestic company’s currency) prior to the expected transaction. This ensures the cost of future transactions and guarantees that domestic companies will pay the price they want to pay.
- Money market hedging is a tool for managing currency or exchange rate risk.
- This allows companies to fix exchange rates prior to dealing with foreign parties.
- Money market hedging can provide some flexibility, such as hedging only half the value of a transaction.
- Money market hedging is usually more complex than other forms of forex hedging, such as forward contracts.
Without money market hedging, domestic companies could be affected by exchange rate fluctuations and the prices of transactions could change dramatically. Changes in exchange rates can reduce the cost of transactions, but fluctuations can increase the cost of transactions and, in some cases, exorbitant costs.
Money market hedging provides flexibility in the amount covered. For example, a company may want to hedge only half the value of future transactions. Money market hedging is also useful for hedging in exotic currencies such as the Korean won, where there are few alternatives to hedging foreign exchange risk.
Money market hedging example
Suppose an American company knows that it needs to buy supplies from a German company within six months and that it needs to pay in euros instead of dollars. The company can use money market hedging to lock the value of the euro against the dollar at current rates. This gives US companies an accurate picture of transaction costs, even if the dollar falls against the euro in six months. It will be in dollars and you can budget accordingly. Money market hedging is performed in the following ways:
- Purchase the present value of the foreign currency transaction amount at the spot rate.
- Deposit the purchased foreign currency in the money market and receive interest until payment is made.
- Pay in foreign currency using your deposit.
Money Market Hedge Forward Contract
If a U.S. company cannot or does not want to use money market hedging, it can use forward contracts, foreign exchange swaps, or simply take the opportunity to pay exchange rates within 6 months. increase. Money market hedging is typically more complex than forward contracts, so companies may choose not to use money market hedging when performing a large number of transactions.