Money Market Hedge (Mmh)

Topics: Foreign exchange market, Forward contract, Arbitrage Pages: 2 (402 words) Published: November 12, 2010
Money Market Hedge (MMH)
(a) To hedge export receivable in USD
(i) borrow the present value of USD
(ii) convert the USD to AUD in spot market

(this allows you to know how much AUD you will get for the receivable, therefore hedged)
(iii) The future value of this AUD is equivalent to the USD receivable, an implied forward rate is obtained.
(b) To hedge import payable in USD
(i) borrow AUD (pay AUD interest rate)
(ii) convert the AUD in spot to USD
(iii) invest the USD to earn USD interest. This will give sufficient USD later to make payment for the payable. MMH for payable is slightly more complicated. One needs to compute the PV of the payable, and then use the spot exchange rate to find out the equivalent AUD that needs to be borrowed for the hedge. The future value of the AUD is equivalent to the USD payable, therefore, an implied forward rate is obtained. MMH is similar to CIA, but one is hedging and the other is arbitrage. An example is available in tutorial. Example: Import payables: EUR1 million due in one year. 1-year interest rates for Australian dollar and euro are 5.5% and 2%, spot exchange rate is EUR0.5854/AUD. MMH: First, calculate the present value of EUR1 million which equals 1m/1.02 = EUR0.980392m. Second, calculate the equivalent in AUD, ie., 0.980392/0.5854 = AUD1.6747389m. Therefore, to conduct a money market hedge, one would borrow AUD1.6747389 and convert it to EUR at 0.5854 and then invest the EUR at 2% pa for one year. In one year it will accumulate to EUR1 million, sufficient to pay off the debt: 1.6747389(0.5854)(1.02) = EUR1 million

In the MMH above, the one year future value of AUD1.6747389 million = 1.6747389(1.055) = AUD1.7668495 million, is equivalent to EUR1 million payable. Therefore, the implied forward rate is 1/1.7668495 = EUR0.5660/AUD. If interest rate parity holds, there is no difference between forward hedge and money market hedge. In...