The money market can be used to hedge against exchange rate fluctuations by borrowing an amount in foreign currency equal to the value of, say, invoiced exported goods, exchanging it for the domestic currency at the spot rate, and then using the receipts from the customer to repay the loan. Effectively, this method uses the matching principle we saw earlier in respect of internal hedging, but applies it to the creation of an asset Liability in the money market, to match the liability/asset which needs to be hedged. Thus, a UK exporter due a sum of dollars in three months’ time may eliminate the exchange rate exposure by borrowing the sum of dollars at the outset -creating a matching liability. It can then exchange the dollars for sterling at the current spot rate, fixing the exchange rate on the transaction. The sterling can then be invested for the three months. If the money markets and the foreign exchange markets are in equilibrium, we can expect that interest rate parity holds and the interest earned on the sterling investment will offset any change in the exchange rate. The dollars received can be used to pay off the loan, plus interest accrued, in three months’ time. This should, then, provide the same result as a forward currency hedge. Companies which regularly operate this form of hedging usually hold different accounts with their banks for the major currencies in which they trade. In this way, money can be deposited easily, and interest earned when there are surplus funds, and borrowing (overdraft) facilities are readily available when necessary.
Consider the following example.
A UK company is due $500,000 in three months’ time from a customer in the USA. The interest rate is 6% pa and the spot exchange rate is $1.93/£.The company stands to lose value in sterling on the asset (the $Yzm) if the dollar weakens against the pound. To hedge this in the money market involves creating a matching dollar liability -a loan equivalent to $Yzm in three months’ time -exchanging this for sterling (thereby fixing the exchange rate on the transaction) and investing the proceeds for three months, and then using the receipt of the $500,000 to pay off the loan, plus interest accrued.