Money market hedging – ACCA Financial Management (FM)
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have you mistakenly wrote convert it to $ at spot rate in payment in example 7 when in fact we convert it in pounds ?
No, he’s wrote convert to $ correctly.
We convert the amount we borrow in 拢 into $ now, so we can deposit the $, to gain interest in 3 monts to pay $8,000,000 to the supplier.
Hope this helps.
Just out of curiosity sir, is this similar to “shorting” stocks? where you borrow money to bet against the exchange rate?
Not really. Shorting stocks (shares) is when you sell shares and intend to buy back later (hoping that the share price will have fallen).
There is still risk when shorting shares (because the share price obviously might not fall). Money market hedging is removing the exchange rate risk because whether the exchange rate rises or falls in the future becomes irrelevant.
Thank you so much for the lecture sir.
On example 7 on converting Dollars to Pounds why was the rate of 1.6201 used instead of 1.6283? In the earlier example you stated the rate that gives us a disadvantage is the one to use, if 1.6283 was used the amount was going to be 拢4,835 728 which is lower than 拢4,860,204..
Thank you
We are buying $’s in order to invest (and therefore the rate to use is the one that costs the more pounds).
Awesome sir. Well understood.
Dear Sir,
When will see the annual interest rates like the ones in examples 6 and 7 on Money market hedging, do we always assume they are simple interest rates? Will they ever be quoting the effective annual interest rates?
Thanks and Regards,
Tim
For money market hedging, interest rates are always dealt with as in my examples.
Hello sir, i have a question. In example 6 we are borrowing money at todays spot rate and depositing it so that the future exchange rate does not affect us, but after 3 months we will have to repay the bank the exact amount we borrowed with the money that we receive from the customer. Wouldn’t the future exchange rate matter here since the amount we receive in the future (that we will repay the bank with) might be different from what we borrowed from the bank because of the rate?
The amount borrowed from the bank is the amount that we will be receiving from the customer after accounting for the interest that will have to be paid on the borrowing.
we are borrowing dollars now to convert it to pounds today at spot rate in order to hedge the risk, but why are we depositing pounds for 3 months and how is it helping in hedging risk for us?
It means we get a fixed amount of pounds in 3 months time as opposed to leaving it at risk and getting an uncertain amount of pounds in 3 months time.
but are we not paying or receiving in dollars? so why the deposit is in pounds for 3 months?
The dollars need to be converted to pounds at some stage. If we do nothing then the amount in 3 months is uncertain because we do not know what the spot rate will be in 3 months. If we use money market hedging then the amount in three months is fixed, whatever happens to the exchange rate.
Hello Sir,
In example 6 we got 3.6*3/12 = 0.009% and then you multiplied the converted amount with 1.009% I do not understand why did you do it 1.009% ? and why not simply 0.009% ?
It does not equal 0.009%! 3.6*3/12 = 0.9% which is the same as 0.009.
Adding on 0.9% of the amount is the same as multiplying the amount by 1.009. Try it and see 馃檪
If you are still unsure that look at the Paper MA (was F2) free lectures on interest to remind yourself.
Ooh now I realized how stupid was my question.
Sorry and thank you for helping.. 馃檪
You are welcome 馃檪
John, I just have a tiny question. In the examples that you’ve given, the question mentions that the interest rates are “current 3 month interest rates” so why do you multiply that by 3/12 again?
Interest rate are always quoted as yearly rates. The yearly rate offered will be different for different lengths or borrowing or depositing. For example, a bank may give interest at the rate of 5% per year if you deposit for 3 months, but might give interest at the rate of 6% per year if you deposit for 6 months. This is how interest rates are quoted in real life as well as in exams.
Ohh that makes sense now. Thank you so much for clearing that up! 馃檪
Dear Mr. Moffat,
Thank you for your lectures they are of utomst help.
I understand this concept when receiving money but when paying such as in example 7 what about borrowing in the currency one would have to poy in the future now? (Borrwing less ammount deposit it and then it would mature to the ammount due)
Thank you
That is effectively what we do 馃檪
Hi John,
will it wrong in example 7
When i put it this way,then start with deposit now
1.Deposit now
2.Covert to spot
3.Borrow
Hello sir,
I have a question, how we will use the home currency rates given in Money market hedging. Like in example 6&7 UK LIBOR rates(in percentage) are given how we will decide which one and when to use, lower rate or higher rate e.g in example 7 you have used 9.9% instead of 9.2% and in example 6 you have choose 3.6% instead of 3.9% .how t decide which one to choose.?
The lower rate applies if we are depositing money, the higher rate applies if we are borrowing money (the banks make their profits because of the difference 馃檪 )
Thank you sir for our answer.
I have another question , you calculated backwards while calculating deposit(payment) using money market Hedging . Can we calculate it in same way as we calculated Money market hedging receiving income?
Sir in example 6 of money market hedging Reciepts calculation you used 3.6% instead of 3.9%,why?as we can see 3.6% is lower than 3.9% and while receiving currency we use LOWER RATE. Kindly explain.
And in example 7 you used 9.9% instead of 9.2% ,why?
First question:
No we can’t. We need to work backwards to determine how much money we need to deposit and therefore how much to borrow and convert.
Second question:
In example 6 we borrow $’s (so at the higher $ interest rate) and deposit Pounds (so at the lower Pound interest rate).
In example 7 we borrow Pounds (so at the higher Pound interest rate) and deposit $’s (so at the lower $ interest rate).
Sir ,
In INTEREST RATE PARITY or PURCHASE POWER PARITY formula what is the 1st currency means, which currency is first currency we will consider?
This has nothing to do with money market hedging and is explained in my lectures on “forecasting foreign currency exchange rates”.
Hi teacher,
I have similar question on the spot rate for example 7. Normally we convert the spot rate which give us lesser amount, so should be using 1.6283? Or because we work backward, so we chose the spot rate also at opposite way?
Thank you!
We are paying money (not receiving) and therefore use the rate that means we pay the bigger amount.
Thank you so much for clearing my doubt! Appreciate it!
You are welcome 馃檪
Hello there,
If we need to Borrow (in example 6) $ 5 Million then what about the interest that we have to pay on the amount.Why did you not consider it to be relevant for the Question or Foreign Exchange risk at all.?
Thanks for the lecture.
But we didn’t borrow $5M. We borrowed $4,928,536 so that when the interest on that amount is added on we will owe $5M and the receipt will repay the borrowing including the interest.
Hi Sir,
For example 7, after all the calculation, if I have this kind of question in the exam, on the answer sheet Can I conclude and write down that ” Q need to deposit 4,980,494 pounds into the bank today to have $8,000,000 to pay in 3 months.”
I don’t know what to conclude because the question is “Show how Q can use the money markets to hedge the risk”.
Thank you so much!!!
The example is a lecture example so that I can show how we use the money markets. In the exam questions on this would be in Sections A or B and so you will not be typing anything – the question will state what numbers are required.
You will find plenty of examples of how it can be asked in the exam in your Revision Kit.
It’s one day before the exam and still i can wrap my head around this area of the syllabus, so am just gonna go ahead and hope it won come up.
Dear John,
Thank you for a great lecture, again.
Quick question on Example 7.
– Conversion: why convert at spot is 1.6201 instead of 1.6283. Thus the company has to sell dollars and buy 拢 to invest them, I thought, in this case, we should use 1.6283.
many thanks Anna
No – we are buying $’s so that we can put them on deposit and have enough in 3 months so as to be able to pay the $’s that we owe,
thank you, a got a little confused.
Hello Mr Moffat
Thank you for your lecture in first place 馃檪
I do not understand one thing we borrowing dollars and we pay interest but all of the sudden we have to borrow less than we originally needed i thought that it should be in this way $5m x 1.0145
why do we divide it ?
Regards
Matt
We borrow less than we will need on the future date because by the time we need the money it will have earned interest and so there will be more available.
Instead of borrowing money, could we convert today using spare cash then deposit the dollars, which would save us paying any interest?
But you would then be losing interest you could have been earning on the spare cash 馃檪
this type of market hedging questions is important in exam ?
If we have to receive the $5m in example 6. Why are we borrowing $ in the first place?
In order to be able to convert at todays exchange rate instead of taking the risk of waiting and the exchange rate changing.
I do suggest that you watch the lecture again.