# Money Market Hedge

Money market hedge is a hedge against exposure to foreign currency risk, created by borrowing or depositing a suitable sum of money now to fix payments and receipts in domestic currency.

Any business that engages in foreign currency transactions in which the date of payment/receipt is delayed, is exposed to the risk that the value of foreign currency may change between the date of transaction and the date of payment/receipt.

The steps needed to create a hedge using money market depend upon whether the company expects to pay or receive a foreign currency sum. This is demonstrated below:

## Foreign Currency Receipt

If a company is expecting a receipt of foreign currency from, say a customer, it is exposed to the risk that the foreign currency will be worth less compared to domestic currency when it is ultimately received by the company. Using money market, the company can hedge against currency risk by borrowing in foreign currency now, an amount equal to the present value of the sum receivable in future. The amount to borrow is calculated using the following formula:

$$ Foreign\ Loan (F_l) = \frac {Foreign Receipt} {\left( 1+r_{fb} \right)^n} $$

Where *r _{fb}* is foreign currency borrowing rate for a given period and

*n*represents the number of periods between present and date of receipt.

At the end of the exposure period, the sum of interest and principle payable on foreign currency loan will exactly match the amount ultimately received in foreign currency which means the actual receipt from the customer will be utilized to repay the loan.

The company immediately converts the foreign loan to domestic currency at the spot exchange rate. It is assumed that the domestic currency sum is deposited at domestic interest rate for the period until the receipt of foreign currency. In case of direct quote:

$$ Domestic\ Deposit\ (D_d)=\ F_l \times Spot\ Rate\ $$

The company earns interest on the the domestic currency deposited. The ultimate effect of this hedging strategy is that the company obtains a sum of domestic currency calculated using the formula:

$$ Final\ Domestic\ Value = D_d \times \left(1+r_{dd}\right)^n $$

Where *r _{dd}* is the domestic deposit rate for the period and

*n*represents the number of periods. The hedging fixes the exchange rate for the company at following value:

$$ Effective\ Exchange\ Rate=\frac{Final\ Domestic\ Value}{Foreign\ Receipt} $$

## Foreign Currency Payment

If a company must pay foreign currency in future to, say a supplier, it is exposed to the risk of appreciation of foreign currency against domestic currency. A hedge via money market may be created by depositing a calculated sum of foreign currency for the period between ‘now’ to the date of payment.

The principle plus interest receipt at the end of deposit period must equal the amount to be paid so that when the deposit period ends, the proceeds from bank are used to pay the supplier. This means the foreign deposit is the present value of foreign payment.

$$ Foreign\ Deposit (F_d) =\frac{ Foreign\ Payment }{ \left( 1 + r_{fd} \right) ^n} $$

Where r_{fd} is the foreign deposit rate for a given period and n are the number of periods for the duration between ‘now’ and date of payment.

The company will need to buy currency for foreign deposit. It is assumed that a domestic loan is obtained to buy the foreign currency. The amount to be borrowed if the exchange quotes are direct is given by the following formula:

$$ Domestic\ Loan\ (D_l) = F_d \times Spot\ Rate $$

The total liability on domestic loan at the end of exposure period is given by:

$$ Final\ Domestic\ Value = D_l \times \left(1+r_{db}\right)^n $$

Where *r _{db} is* the domestic borrowing rate for a given period and n are the number of periods in the duration of exposure to risk.

$$ Effective\ Exchange\ Rate=\frac{Final\ Domestic\ Value}{Foreign\ Payment} $$

## Example

Suppose the domestic currency of a company is DC and foreign currency in which the company transacts is FC. The company has to pay FC 100,000 to a supplier in 1 year. A major customer will also pay the company FC 20,000 in 6 months. The exchange rate FC-DC is volatile and the company wishes to fix it’s payable and receivable in DC. The annual interest rates are 8% and 10% for DC and FC respectively. The spot exchange rate is 3 units of DC per 1 unit of FC. Ignoring the difference between lending and borrowing rates of interest; and the difference between bid and offer exchange quotes, a hedge using money market be created as follows:

### Receipt

$$ Number\ of\ Periods = n = \frac{6}{12} = 0.5 $$

$$ Foreign\ Loan = \frac {20,000} {\left( 1+ 10\% \right) ^{0.5} } \approx 19,069 $$

$$ Domestic\ Deposit =\ 19,069 \times 3 \approx 57,207 $$

$$ Final\ Domestic\ Value = 57,207 \times \left(1+8\% \right)^{0.5} \approx 59,451 $$

$$ Effective\ Exchange\ Rate=\frac{59,451}{20,000} \approx 2.973 $$

### Payment

$$ Number\ of\ Periods = n = 1 $$

$$ Foreign\ Deposit =\frac{100,000 }{ \left( 1 + 10\% \right)^1} \approx 90,909 $$

$$ Domestic\ Loan = 90,909 \times 3 $$

$$ Final\ Domestic\ Value = 272,727 \times \left(1+8\%\right)^1 \approx 294,545 $$

$$ Effective\ Exchange\ Rate=\frac{294,545}{100,000} \approx 2.945 $$

Written by Irfanullah Jan and last modified on