The money market hedge

A money market hedge involves a loan contract and a source of funds to carry out that contract in order to hedge transaction exposure. In this case, the contract represents a loan agreement. Assume that an American company has a British pound import payable in 90 days. To hedge transaction exposure from this import payable, the American company may borrow in dollars (loan contract), convert the proceeds into British pounds, buy a 90-day British Treasury bill, and pay the import bill with the funds derived from the sale of the Treasury bill (source of funds). Of course, it can buy British pounds in the foreign-exchange spot market when the import bill becomes due, but this approach involves transaction risk.

A money market hedge is similar to a forward market hedge. The difference is that the cost of the money market hedge is determined by differential interest rates, while the cost of the forward market approach is determined by the forward premium or discount. If foreign-exchange markets and money markets are in equilibrium, the forward market approach and the money market approach incur the same cost.

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