How the Money Market Hedge Works

A money market hedge is a technique for hedging foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances, and commercial paper are traded.

Since there are a number of avenues such as currency forwards, futures, and options to hedge foreign exchange risk, the money market hedge may not be the most cost-effective or convenient way for large corporations and institutions to hedge such risk. However, for retail investors or small businesses looking to hedge currency risk, the money market hedge is one way to protect against currency fluctuations without using the futures market or entering into a forward contract.

Let’s begin by reviewing some basic concepts with regard to forward exchange rates, as this is essential to understand the intricacies of the money market hedge.

A forward exchange rate is merely the spot exchange (benchmark) rate adjusted for interest rate differentials. The principle of “Covered Interest Rate Parity” holds that forward exchange rates should incorporate the difference in interest rates between the underlying countries of the currency pair, otherwise an arbitrage opportunity would exist. 

For example, assume U.S. banks offer a one-year interest rate on U.S. dollar (USD) deposits of 1.5%, and Canadian banks offer an interest rate of 2.5% on Canadian-dollar (CAD) deposits. Although U.S. investors may be tempted to convert their money into Canadian dollars and place these funds in CAD deposits because of their higher deposit rates, they obviously face currency risk. If they wish to hedge this currency risk in the forward market by buying U.S. dollars one year forward, covered interest rate parity stipulates that the cost of such hedging would be equal to the 1% difference in rates between the U.S. and Canada.

We can take this example a step further to calculate the one-year forward rate for this currency pair. If the current exchange rate (spot rate) is US$1 = C$1.10, then based on covered interest rate parity, US$1 placed on deposit at 1.5% should be equivalent to C$1.10 at 2.5% after one year. Thus, it would be shown as:

US$1 (1 + 0.015) = C$1.10 (1 + 0.025), or US$1.015 = C$1.1275

And the one-year forward rate is therefore:

US$1= C$1.1275 ÷ 1.015 = C$1.110837

Note that the currency with the lower interest rate always trades at a forward premium to the currency with the higher interest rate. In this case, the U.S. dollar (the lower interest rate currency) trades at a forward premium to the Canadian dollar (the higher interest rate currency), which means that each U.S. dollar fetches more Canadian dollars (1.110837 to be precise) a year from now, compared with the spot rate of 1.10.

The money market hedge works in a similar manner as forward exchange, but with a few tweaks, as the examples in the next section demonstrate.

Foreign exchange risk can arise either due to transaction exposure (i.e., due to receivables expected or payments due in foreign currency) or translation exposure, which occurs because assets or liabilities are denominated in a foreign currency. Translation exposure is a much bigger issue for large corporations than it is for small business and retail investors. The money market hedge is not the optimal way to hedge translation exposure – since it is more complicated to set up than using an outright forward or option – but it can be effectively used for hedging transaction exposure.

If a foreign currency receivable is expected after a defined period of time and currency risk is desired to be hedged via the money market, this would necessitate the following steps:

1. Borrow the foreign currency in an amount equivalent to the present value of the receivable. Why the present value? Because the foreign currency loan plus the interest on it should be exactly equal to the amount of the receivable.
2. Convert the foreign currency into domestic currency at the spot exchange rate.
3. Place the domestic currency on deposit at the prevailing interest rate.
4. When the foreign currency receivable comes in, repay the foreign currency loan (from step 1) plus interest.

Similarly, if a foreign currency payment has to be made after a defined period of time, the following steps have to be taken to hedge currency risk via the money market:

1. Borrow the domestic currency in an amount equivalent to the present value of the payment.
2. Convert the domestic currency into the foreign currency at the spot rate.
3. Place this foreign currency amount on deposit.
4. When the foreign currency deposit matures, make the payment.

Note that although the entity who is devising a money market hedge may already possess the funds shown in step 1 above and may not need to borrow them, there is an opportunity cost involved in using these funds. The money market hedge takes this cost into consideration, thereby enabling an apples-to-apples comparison to be made with forward rates, which as noted earlier are based on interest rate differentials.

Example 1: Consider a small Canadian company that has exported goods to a U.S. customer and expects to receive US$50,000 in one year. The Canadian CEO views the current exchange rate of US$1 = C$1.10 as favorable, and would like to lock it in, since he thinks that the Canadian dollar may appreciate over the year ahead (which would result in fewer Canadian dollars for the U.S. dollar export proceeds when received in a year’s time). The Canadian company can borrow US$ at 1.75% for one year and can receive 2.5% per annum for Canadian-dollar deposits.

From the perspective of the Canadian company, the domestic currency is the Canadian dollar and the foreign currency is the US dollar. Here’s how the money market hedge is set up.

1. The Canadian company borrows the present value of the U.S. dollar receivable (i.e. US$50,000 discounted at the US$ borrowing rate of 1.75%) = US$50,000 / (1.0175) = US$49,140.05. After one year, the loan amount including interest at 1.75% would be exactly US$50,000.
2. The amount of US$49,104.15 is converted into Canadian dollars at the spot rate of 1.10, to get C$54,054.05.
3. The Canadian dollar amount is placed on deposit at 2.5%, so that the maturity amount (after one year) = C$54,054.05 x (1.025) = C$55,405.41.
4. When the export payment is received, the Canadian company uses it to repay the U.S. dollar loan of US$50,000. Since it received C$55,405.41 for this U.S. dollar amount, it effectively locked in a one-year forward rate = C$55,405.41 / US$50,000 or US$1 = C$1.108108

Note that the same result could have been achieved if the company had used a forward rate. As demonstrated in the previous section, the forward rate would have been calculated as:

US$1 (1 + 0.0175) = C$1.10 (1 + 0.025); or US$1.0175 = C$1.1275; or US$1 = C$1.108108

Why would the Canadian company use the money market hedge rather than an outright forward contract? Potential reasons could be that the company is too small to obtain a forward currency facility from its banker; or perhaps it did not get a competitive forward rate and decided to structure a money market hedge instead.