A money market hedge is an attempt to offset potential currency fluctuations that could cause a financial loss. Money market hedges ensure that surprise currency fluctuations will not wipe out the profit from a transaction and won't cause unneeded financial volatility. However, this certainty comes at a cost. Money market hedges must be paid for through a bank or broker.
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Money market hedges are used by anyone who has different assets or liabilities denominated in different currencies and wants them to behave as if they were denominated in the same currency. For example, a company in the United State might export products to the UK and get paid months later in pounds. If the pound drops in value, the company could end up losing money on the transaction.
Other uses are financial. Some people borrow in currencies other than their home currency. For example, many foreign companies borrow in U.S. dollars or Japanese yen. If they are concerned that a rise in the value of the dollar or yen could hurt their finances, they can hedge. An investor who owns shares in an overseas company can hedge against the risk that the share price will rise while the currency falls.
At its simplest, a money market hedge is an agreement to exchange a certain amount of one currency for a fixed amount of another currency, at a particular date. For example, suppose a business owner in the U.S. expects to be paid 1,000 pounds in six months. This investor could create an agreement now to exchange 1,000 pounds for U.S. dollars at roughly the current exchange rate. Thus, if the pound dropped in value by the time the business owner got the payment, he would still be able to exchange the payment for the original quantity of U.S. dollars specified.
Banks are often able to create money market hedges for their business customers. Local banks may have difficulty, but large banks can easily accommodate this. Foreign exchange brokers can also assist in making such trades. An investor expecting to receive dollars in a year could bet against them through a Forex (foreign exchange) broker and expect the bet to rise in value as the payment falls, or vice versa. Smaller businesses can "hedge" their money market risks by requesting payment in the currency they typically use.
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