Elvis Picardo is a regular contributor to thedailysplash.tv and has 25+ years of experience as a portfolio manager with diverse capital markets experience.
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.
Forward Exchange Rates
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: