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 helps a domestic company reduce its currency risk when doing business with a foreign company. It 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 can lock in a price that it's willing and able to pay.
BREAKING DOWN Money Market Hedge
Without a money market hedge, the domestic company would be subject to exchange-rate fluctuations that could dramatically alter the transaction’s price. While exchange-rate fluctuations could cause the transaction to become less expensive, they 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 the transaction. It is also useful for hedging in exotic currencies, such as the South Korean won, where forward contracts do not get traded actively.
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 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 and receiving interest until payment is made.
- Using the deposit to make the foreign currency payment.
(For further reading, see: The money market hedge: How it works.)
Money Market Hedge Alternatives
If the U.S. company did not want to use a money market hedge, it could also use a forward contract, FX 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. (To learn more, see: How Companies Use Derivatives to Hedge Risk.)