Question

a) Describe the mechanism of a money market hedge in which a firm wishes to eliminate the risk of devaluation of its functional currency at the time of receiving a future payment for a good sold to a company in a foreign currency.

b) Explain what is the cost of this operation for the firm.

c) Explain what is the main counterparty risk of this operation for the firm.

Answer 1

The money market hedgeing is done to protect ourselves from the fluctuation in the international market.

When a company trades in international market it is always afraid of the appreciation and depreciation of the functional curreny thus to mitigate this risk they opt for money market hedges.

In this technique when a company has some recievables in the foreign currency it is afraid of the functional currency rising and thus to protect itself it enters into money market hedge.

It has foreign currency recievables so what it does is that it borrows the present value of the recievables and converts it into spot rate available and then invests the amount received on conversion in functional currency into the lending rates available in the functional market then after the end of tenure when he receives the foreign currency it is directly used to settle the borrowed amount directly and thus no need to convert into functional currency also he will recieve the invested amount along with the interest thus he has successfully converted the recievables at the spot ratesand thus prevented from the fluctuation in international markets.

Part B

The cost of the operation of the firm is the amount of interest that would be paid when we borrow the amount as in this case we had borrowed the foreign currency and thus we had to pay the interest in terms of foreign currency on the loan however we don't have to enter in any of the transaction separately to do that also the company might have to pay some transaction cost in the transaction.

Part C

These contracts are all Over the counter and not Exchange traded thus there is always a Counterparty default risk involved in the transaction.