Hedging Exchange Rate | Currency risk using Money market hedging
Let’s say that you were a UK manufacturer exporting to the US and in three months you are due to receive US$2m. You would suffer no currency risk if that US$2m could be used then to settle a US$2m liability; that would be matching the currency inflow and outflow. However, you don’t have a US$2m liability to settle then – so create one that can soak up the US$. You can create a US$ liability by borrowing US$ now and then repaying that in three months with the US$ receipt. So the plan is:
To work out how many US$ need to be borrowed now, you need to know US$ interest rates. For example, the US$ three month interest rate might be quoted as: 0.54% – 0.66%.
It is important to understand that, although this might be described as a ‘three month rate’ it is always quoted as an annualised rate. One rate is what you would earn in interest if the money was on deposit, and the other is the rate you would pay on a loan. On the US$ loan we will be charged 0.66% pa for three months and the loan has to grow to become US$2m in that time. So, If X is borrowed now and three months’ interest is added:
X(1 + 0.66%/4) = 2,000,000
X = $1,996,705
This can be changed now from US$ to £ at the current spot rate, say US$/£ 1.4701, to give £1,358,210.
This amount of sterling is certain: we have it now and it does not matter what happens to the exchange rate in the future. Ticking away in the background is the US$ loan which will amount to US$2m in three months and which can then be repaid by the US$2m we hope to receive from our customer. That is the hedging process finished because exchange rate risk has been eliminated.
So, if the sterling three month deposit rate were 1.2%, then placing £1,358,210 on deposit for three months would result in:
£1,358,210 (1 + 1.2%/4) = £1,362,285