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hello sir , im having great trouble understanding the logic behind hedging a payment using money markets, now after 3 months when the dollar deposit matures which is basically the exact amount we need to pay the supplier, we use that to pay the supplier ,
but we also have to pay the bank from which we bought the pounds, now from what will we pay the bank when we have already paid the supplier? and i dont understand the point in hedging to begin with , why would anyone borrow more keeping in mind he has to pay someone in future essentially creating 2 obligations after 3 months just to hedge the exchange rate risk? is the risk that big?
The only way of removing the risk of future exchange rate movements is to convert the money today at the current spot rate.
In order to be able to convert today we need to borrow money (and repay it in 3 months time). Having got the foreign currency today, there is no point in paying it to the supplier immediately – we don’t need to pay them for three months – so we put it on deposit and earn some interest on it.
We are not creating two obligations at all. The only cash flow will be in 3 months time – if we had not created the hedge then the flow would be paying the supplier, but the amount would be uncertain because of exchange rate fluctuations. With the hedge, the flow is repaying the borrowing, but this is a fixed amount because it was borrowed at fixed interest.
I do suggest that you watch the lectures again (and if necessary the relevant F9 lectures also, because money market hedging is revision of F9).
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