Hedging strategies and effectiveness - Money market hedges a...

Learning Outcomes

After reading this article, you will be able to explain the principles and mechanics of both money market hedges and forward cover as foreign currency risk management tools. You will understand their strengths, limitations, and practical application to currency exposures. By the end, you should be able to evaluate the comparative effectiveness of these strategies and advise on their appropriate use in accordance with ACCA AFM exam standards.

ACCA Advanced Financial Management (AFM) Syllabus

For ACCA Advanced Financial Management (AFM), you are required to understand how to identify, evaluate, and implement hedging strategies for foreign currency risk, particularly using money market and forward contracts. Revision should focus on:

• Explaining the mechanics and purpose of money market hedges and forward cover
• Calculating and comparing outcomes using money market and forward methods
• Assessing which strategy is more suitable given a company’s risk exposure and context
• Identifying the advantages and disadvantages of each approach
• Advising on common practical considerations and sources of exam error

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Which type of hedging contract guarantees a pre-agreed exchange rate for a future currency payment:
   1. Currency option
   2. Money market hedge
   3. Forward contract
   4. Natural hedge

2. True or false? A money market hedge requires borrowing or depositing now to fix the future value of a foreign currency transaction.

3. Briefly identify a situation when a money market hedge may be preferable to a forward contract for managing foreign exchange risk.

4. List two typical disadvantages of forward cover compared to a money market hedge.

Introduction

Controlling foreign currency risk is essential for any company involved in cross-border trade. Two of the most widely tested strategies at ACCA AFM are forward exchange contracts (forward cover) and money market hedges. Forward cover fixes the rate at which a future currency transaction will be settled, providing certainty. A money market hedge achieves a similar result by using a combination of spot exchange transactions and borrowing or depositing, replicating the effect of a forward contract when markets are efficient.

It is important to know not only how to perform these calculations, but also when use of each method is appropriate, and to understand their respective advantages and limitations in practice.

Key Term: forward contract
An agreement to buy or sell a specific amount of foreign currency at a fixed exchange rate on a set future date. Used to lock in rates and eliminate uncertainty.

Key Term: money market hedge
A strategy to hedge future foreign currency payables or receivables by using spot foreign exchange transactions and an offsetting deposit or borrowing, thereby fixing the effective exchange rate for the future settlement.

Money Market Hedge: Mechanics and Application

A money market hedge uses current spot and money market rates to fix the effective exchange rate for a future currency transaction. The company borrows or deposits the present value of the future cash flow in the relevant currency, converts via the spot rate, and repays the borrowing or collects the deposit at the required date. This secures certainty over the cost or receipt despite future exchange rate uncertainty.

Payables Money Market Hedge

To hedge a future foreign currency payment:

1. Calculate the present value of the future payable using the foreign currency interest rate.
2. Borrow this amount in the foreign currency, convert to home currency at spot, and pay into a deposit or reduce debt.
3. On the settlement date, use the proceeds to settle the liability.

Receivables Money Market Hedge

For a future foreign currency receipt:

1. Borrow the present value in the foreign currency, repay with the incoming funds at maturity.
2. Convert the borrowed sum to home currency at spot and invest or use as needed.
3. The net result fixes the home currency outcome regardless of the future spot rate.

Key Term: present value (PV)
The current value of a given future sum, discounted at the relevant interest rate over the period until settlement.

Worked Example 1.1

Scenario: A UK importer must pay €1,500,000 in 3 months. The current spot rate is €1.20/£1. Euro deposit rates are 2% p.a.; UK deposit rates are 4% p.a.

Question: Calculate the sterling cost using a money market hedge (ignore transaction costs).

Answer:

1. Calculate 3-month PV of payables:
   PV = €1,500,000 / [1 + (0.02 × 3/12)] = €1,492,537
2. Borrow €1,492,537 now at 2% p.a. for 3 months.
3. Convert to sterling at spot:
   £ = €1,492,537 / 1.20 = £1,243,781
4. In 3 months, pay €1,492,537 × 1.005 = €1,500,000 (to settle the invoice). The effective sterling cost is £1,243,781 (plus sterling interest, if any, if the cash is borrowed instead of using available funds).

Forward Cover: Principles and Steps

A forward contract establishes a fixed exchange rate for a specific future date and amount. This provides certainty over the future home currency amount, useful for both payables and receivables.

To use a forward contract:

• Agree the forward rate today for the required amount and date.
• On settlement, exchange at this rate irrespective of the then-prevailing spot rate.

Worked Example 1.2

Scenario: Using the same facts as Example 1.1, the 3-month forward rate is €1.19/£1.

Question: What is the sterling cost if the company uses forward cover?

Answer:
Payable in 3 months = €1,500,000 / 1.19 = £1,260,504
The forward contract locks in this amount, regardless of what happens to the euro/sterling spot rate on the settlement date.

Comparing Money Market Hedges and Forward Contracts

In efficient markets, both hedges should have near-identical outcomes, since forward rates are determined by spot rates and interest differentials (interest rate parity). However, in practice, small differences arise due to transaction costs, credit limits, or the availability of instruments in specific currencies or amounts.

Key Term: interest rate parity
The principle that forward exchange rates reflect the interest rate differential between two currencies, ensuring no arbitrage opportunities.

Key Term: transaction exposure
The risk of exchange rate fluctuations affecting the value of specific contracted foreign currency transactions.

Worked Example 1.3

Scenario: When would a company choose a money market hedge in preference to forward cover?

Answer:

• The forward market may not exist, or contracts may not be available for the required currency or amounts.
• The company may have a credit limit with its bank, preventing further forward contracts.
• Interest rates may make money market hedging marginally cheaper due to current liquidity.

Strengths and Limitations of Each Strategy

Advantages and Disadvantages

Exam Warning

In exam questions, always check the direction of the exchange rate quote and confirm whether the company is buying or selling the foreign currency. Using the wrong rate or setting up the hedge from the wrong viewpoint is a common source of error.

Revision Tip

In multiple-step hedging calculations, clearly lay out each step. State assumptions (such as whether the company has spare cash or must borrow) to maximize marks for workings and explanations.

Summary

Both money market hedges and forward contracts offer reliable methods for fixing the home currency value of future foreign currency flows. While they achieve similar economic effects under normal conditions, they may differ in cost and practical suitability depending on the transaction’s size, timing, and the company’s access to financial markets. Proper analysis should compare outcomes and consider operational constraints before advising on the best approach.

Key Point Checklist

This article has covered the following key knowledge points:

• Identify the mechanics and process of a forward contract and a money market hedge
• Perform calculations for both methods to hedge payables and receivables
• Recognize practical factors affecting method selection (e.g., availability, credit lines, transaction sizes)
• Explain why both methods may produce similar results under interest rate parity
• List and compare the main strengths and weaknesses of each method for exam scenarios

Key Terms and Concepts

• forward contract
• money market hedge
• present value (PV)
• interest rate parity
• transaction exposure