Money market hedge is the process through which organization hedges its foreign exchange rate risk. It is not a readily product available in the market.
Money market hedge follows the matching principle in that it creates asset (bank deposit) against liability (payment) resulting from purchasing goods or services. Similarly, it creates liability (loan) against asset (receivable) resulting from selling goods or services.
Step By Step Process for Money Market Hedge
Money Market Hedge for Receipt
- Borrow cash in foreign currency. Borrowed amount should be less than expected receipts because subsequent deposit will accrue (earn) interest income making deposits equal to receipt at settlement date.
- Sell cash proceeds from foreign currency loan to convert it into home currency.
- Deposit home currency into bank. Deposit will accrue (earn) interest income.
- Use receipts from customer to repay loan in foreign currency and keep deposit. in home currency, as organization is receiving cash from domestic customer on due date in ordinary course of business.
At the time of receipt, organization will have payment in same foreign currency, same amount at same settlement date as that of receipt. Therefore, gain on receipt will be offset by loss on payment and loss on receipt will be offset by gain on payment resulting in no gain/no loss in any case.
Money Market Hedge for Payment
- Borrow cash in home currency. Borrowed amount should be less than required payment because subsequent deposit will accrue interest income making deposit equal to payment at settlement date.
- Buy foreign currency from cash proceeds from home currency loan.
- Deposit foreign currency into bank. Deposit will accrue (earn) interest income.
- Use deposit for payment to supplier in foreign currency and repay loan in home currency as organization is paying their domestic supplier on due date in ordinary course of business.
At the time of payment, organization will have receipts in same foreign currency, same amount at same settlement date as that of payment. Therefore, gain on payment will be offset by loss on receipt and loss on payment will be offset by gain on payment resulting in no gain/no in any case.
In both cases, cost of Hedging will be the different between interest expense on borrowing and interest income on deposit.
Benefits
Money market hedge is not binding on the organization.
Money market hedge results in perfect hedge.
Money market hedge can be made according to timings and amount of foreign currency cash flows.
Hedging can be done for any foreign currency, which is not possible in future contracts.
Money market hedge can also provide longer-term hedge than forward contract and future contract. As you can borrow from and deposit money in the bank for long term.
Payments for lease rentals at fixed amount for a definite period in time.
Limitations
Money market requires organization to borrow in foreign currency, which it may not be able to do so due to poor credit rating.
Money market is more expensive than forward contracts and future contracts as it incurs cost of interest.
