Essay about Foreign Exchange Market and Money Market Hedge

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TRANSACTION EXPOSURE MANAGEMENT Forward Hedge, Money Market Hedge or Both: Empirical Findings

Kashi Khazeh, Salisbury State University, Maryland

Introduction

Two common methods utilized by MNCs to manage transaction exposure to foreign exchange risk are: 1) the forward hedge, and 2) the money market hedge. To determine which of these two strategies is preferable, this study evaluates the empirical relationship between exchange rates, interest rates, and the forward rates. This information is then used to assess: 1) the lowest rate of exchange for payables, and 2) the highest rate of exchange for receivables under the two hedging techniques noted above. Two different, none-euro related hard currencies were included in this study. These are the British pound and the Japanese yen. The specific time period considered was January-December of 1998. Data for the above currencies were obtained from The Wall Street Journal and The Economist.

Description of Empirical Tests and Methodology

A. Efficiency of the Forward Market and Interest Rate Parity Interest rate parity theory predicts that, in an efficient market, observed premiums/discounts (see equation 1) in the forward market for foreign exchange will accurately reflect existing (n-period) interest rate differentials (see equation 2). In the absence of an efficient market, arbitrageurs would find risk-free profit opportunities. To test the validity of the interest rate parity principle (see equation 3), 30, 90, and 180-day premiums/discounts for each currency were compared to contemporaneous, de-annualized interest rate differentials (i.e., 30, 90, and 180-day rates).

p = F0-S0/S0 (equation 1)

where: p = observed forward premium (or discount); F0 = forward rate (in dollars) for delivery in 30, 90, and 180 days; S0 = spot rate (in dollars)

p = [(1 + ih )/(1 + if )] – 1 (equation 2)

where: p = forward premium (or discount) based on interest rate differentials; ih = home interest rate; if = foreign interest rate

p = F0-S0/S0 = [(1 + ih )/(1 + if )] – 1 ( ih - if (equation 3)

B. The Implication of Interest Rate Parity for the Money Market Hedge If interest rate parity holds, and in the absence of transaction costs, the forward hedge and the money market hedge will yield identical results. According to interest rate parity, the forward premium/discount of a currency reflects the interest rate differential of the currencies. Therefore, the hedging of payables/receivables with a forward hedge will result in the same outcome as with a money market hedge. Money market hedges involve taking a money market position to cover a future payable or receivables position. This type of hedging technique, unlike the forward hedge, requires a simultaneous lending and borrowing of home and foreign currencies.

C. Methodology MNCs frequently use forward contracts to hedge their payables and receivables positions that are denominated in a different currency. These corporations enter into a forward contract to offset either their payables or receivables. By this forward contract, MNCs effectively lock in an exchange rate today for a future transaction (i.e., 30, 90, or 180 days later). They either purchase the foreign currency forward in which their payables are denominated, or they sell forward if they have receivables denominated in a foreign currency. In either case, the corporation shifts the exchange rate risk to a different entity. Additionally, one must note that not only are forward contracts irrevocable, but they can backfire (i.e., result in sub-optimal outcomes) as well. They backfire when the spot rate, at the time when payables/receivables are due, is less/more than the contracted forward rate.

Because of the irrevocability of forward contracts, MNCs frequently utilize money market hedges (as opposed to forward hedges) to reduce foreign exchange risk.
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