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.
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.
- 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 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:
- 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.
- Using the 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 a money market hedge is typically more complicated to organize than a forward contract.