Advanced Financial Management · Management of international trade and finance

Forward Contracts and Money Market Hedges for AFM

Updated 11 October 2026 · Fact-checked

A forward contract fixes a future exchange rate with a bank. A money market hedge creates the same certainty by borrowing and depositing in two currencies today, using the spot rate and interest rates. A futures hedge uses exchange-traded contracts. To solve a question, work out the home-currency result of each method and compare them.

Understand Forward Contracts and Money Market Hedges

Transaction risk arises when you will pay or receive foreign currency at a future date. The exchange rate may move before then, so the home-currency value is uncertain. Hedging replaces that uncertainty with a known amount.

A forward contract is an agreement with a bank to buy or sell a set amount of currency at a fixed rate on a fixed date. You pick the rate today. You cannot benefit if the market moves in your favour. The bank quotes two rates, and it always deals in its own favour.

A money market hedge copies the forward rate using the spot market. You borrow or deposit now so that the foreign currency cash flow is matched by a foreign currency asset or liability. You then convert at today's spot rate and carry the home-currency balance at home interest rates. Because of interest rate parity, the result is usually close to the forward result. Small differences come from bid-offer spreads and from different borrowing and deposit rates.

Currency futures are standardised contracts traded on an exchange. They have a fixed contract size and set expiry dates. You take a position that gains when the exchange rate moves against your underlying exposure. The futures gain or loss is settled in cash and added to or deducted from the spot result. Futures are rarely a perfect hedge. Contract sizes force you to round, expiry dates may not match your cash flow date, and the basis (spot price minus futures price) may change.

In the exam you are asked to calculate each outcome, compare them, and recommend one. The recommendation must refer to the scenario: certainty needed, cost, flexibility, and the size and timing of the exposure.

Key rules to remember

Which side of the quote: Bank buys the base currency at the lower rate and sells it at the higher rate; For a quote of $ per €1, you sell euros to the bank at the lower rate and buy euros from the bank at the higher rate. Always choose the rate that is worse for you.
Forward rate (interest rate parity): F = S × (1 + i home × t) ÷ (1 + i foreign × t); This form applies only when the quote is home currency per unit of foreign currency (for example $ per € for a US company). If the quote is the reverse (foreign currency per unit of home currency), invert the interest rate ratio: F = S × (1 + i foreign × t) ÷ (1 + i home × t). Use time t in years. This is used to estimate forwards or check them. In the exam the bank usually gives the forward rate.
Money market hedge: foreign payable: Foreign amount ÷ (1 + foreign deposit rate × t) = foreign currency to deposit now; Buy this at spot (offer side). If you need home currency to do so, borrow it at the home borrowing rate, then multiply by (1 + home borrowing rate × t) for the cost at the payment date. If you have surplus cash, use the home deposit rate as an opportunity cost.
Money market hedge: foreign receivable: Foreign amount ÷ (1 + foreign borrowing rate × t) = foreign currency to borrow now; Convert at spot (bid side). Deposit the home currency at the home deposit rate, multiplied by (1 + home deposit rate × t), to get the amount at the receipt date.
Futures contracts needed: Number of contracts = Exposure ÷ Contract size; Round to the nearest whole contract. Sell futures to hedge a receivable in the foreign currency. Buy futures to hedge a payable in the foreign currency. Check whether the futures price is quoted in the same direction as your exposure.
Futures gain or loss: Gain or loss = (Price movement) × Contract size × Number of contracts; Sold at the opening price and bought back at the closing price: gain if the price fell. A tick value equals tick size × contract size.
Basis and effective rate: Basis = Spot − Futures price. Effective rate ≈ Opening futures price + Closing basis; The futures price locks in the effective rate only if the basis is zero at closing. A change in basis changes the result.
Hedge efficiency: Hedge efficiency = Gain on futures ÷ Loss on the underlying exposure; Compare the gain on the futures with the loss on the exposure over the same period. A result of 100% is a perfect hedge.

How to solve Forward Contracts and Money Market Hedges questions

Use the same sequence for every hedging question. It keeps you from using the wrong rate or the wrong time period.

1Identify whether you pay or receive foreign currency, how much, and when. Note the home currency and the quote direction.
2Choose the correct side of each rate. You deal at the bank's rate that is worse for you.
3Forward: multiply or divide the foreign amount by the forward rate to get the home-currency result at the date.
4Money market: decide whether you deposit or borrow the foreign currency. Calculate the present value using the foreign rate for the period, not the annual rate.
5Convert at spot, then carry the home-currency amount to the cash flow date using the home borrowing or deposit rate for the period.
6Futures: find the number of contracts, the position (buy or sell), the gain or loss on closing, and add it to the spot result at the date. Report the effective rate and the basis effect.
7Compare all outcomes on the same date and in the same currency. Pick the best for a payable (lowest cost) or receivable (highest receipt).
8Add a short recommendation with a qualitative point: for example, certainty, flexibility, cost and counterparty or margin issues.

Quickest way: Rate-side check, then compare at the future date

When to use it: Use under time pressure when a question gives spot, forward, interest rates and possibly futures, and asks which is best.

Write a three-line layout: Forward, Money market, Futures. Fill in the forward first because it is one calculation.
For the money market, always calculate the foreign PV first. A wrong sequence is the most common error.
Convert everything to the future-date home-currency amount. Do not compare a present value with a future value.
Check the answer: a forward and a money market result should be near each other. If they differ by more than a few percent, recheck the period and the rate sides.
Leave futures to the end. Do the contracts and the gain or loss, then state the effective rate.

Common mistakes in Forward Contracts and Money Market Hedges

Using the wrong side of the bid-offer spread
Students pick the first rate quoted or the mid-rate.
Fix: Ask what the bank is doing. If you are buying the foreign currency, the bank sells and you use the higher rate for a $ per € quote. If you are selling it, use the lower rate. Write bid or offer next to each rate.
Using the annual interest rate for a part-year period
The rate in the table is annual and the period is six months or three months.
Fix: Multiply the annual rate by the fraction of the year before you use it. Six months at 3% a year is 1.5%, not 3%.
Mixing up deposit and borrowing in the money market hedge
Students memorise a procedure instead of the logic.
Fix: For a payable you need foreign currency later, so you hold foreign currency now (deposit it). For a receivable you will receive foreign currency later, so you owe foreign currency now (borrow it). Use deposit or borrowing rates to match.
Forgetting the home-currency interest step
The foreign currency is converted at spot and the question seems finished.
Fix: The home-currency amount sits for the whole period. Add the home borrowing cost, or the home deposit interest earned, before you compare with the forward.
Comparing amounts at different dates
Students compare a spot-date amount from the money market with a future-date forward amount.
Fix: Bring every method to the same date. The forward result and the money market result at the payment date are comparable.
Treating futures as a perfect hedge
Students ignore contract size rounding and the basis.
Fix: Round contracts and state any unhedged balance. Show the effective rate and explain that a change in basis affects the outcome.

Worked examples

Example 1

A US company (home currency $) must pay €2,000,000 in six months. Spot is $1.0800–1.0820 per €1. The six-month forward rate is $1.0870–1.0895 per €1. Annual interest rates: euro deposit 3.0%, euro borrowing 4.0%, dollar deposit 4.0%, dollar borrowing 5.0%. Assume the company would borrow dollars to fund the hedge. Calculate the dollar cost using a forward contract and a money market hedge, and state which is cheaper.

Show the solution

The company buys euros, so the bank sells euros. Use the higher rate in each quote.
Forward: €2,000,000 × 1.0895 = $2,179,000 in six months.
Money market: deposit euros now at the euro deposit rate for six months, 3.0% ÷ 2 = 1.5%.
Euros to deposit now = €2,000,000 ÷ 1.015 = €1,970,443 (to the nearest euro).
Buy these euros at spot offer 1.0820: €1,970,443 × 1.0820 = $2,132,020 (rounded).
Borrow this in dollars for six months at 5.0% ÷ 2 = 2.5%: $2,132,020 × 1.025 = $2,185,321 (rounded).
Compare at the same date: forward $2,179,000 against money market $2,185,321. The forward is cheaper by about $6,320.

Answer: Forward contract cost is $2,179,000. The money market hedge costs about $2,185,321. The forward contract is cheaper by about $6,300 and should be chosen on cost, while also giving certainty.

Example 2

A US company expects to receive €5,000,000 in three months. Spot is $1.0800 per €1. A euro futures contract (contract size €125,000, tick size $0.0001) for the expiry date at the time of receipt trades at $1.0850 today. Three months later, spot is $1.0600 and the futures price is $1.0640. The company sells futures today and closes them out at receipt. Calculate the number of contracts, the futures result, the total dollars received, the effective rate and the hedge efficiency.

Show the solution

The company will receive euros, so it fears the euro will fall. It sells euro futures.
Number of contracts = €5,000,000 ÷ €125,000 = 40 contracts.
Sold at 1.0850 and bought back at 1.0640. The price fell by 0.0210, which is 210 ticks. This is a gain.
Futures gain = 0.0210 × €125,000 × 40 = 0.0210 × 5,000,000 = $105,000.
Spot receipt = €5,000,000 × 1.0600 = $5,300,000.
Total = $5,300,000 + $105,000 = $5,405,000.
Effective rate = $5,405,000 ÷ €5,000,000 = $1.0810 per €1.
Check with basis: opening futures price 1.0850, closing basis = 1.0600 − 1.0640 = −0.0040, so effective rate = 1.0850 − 0.0040 = 1.0810. The result matches.
Hedge efficiency: loss on the spot position = (1.0800 − 1.0600) × 5,000,000 = $100,000. Efficiency = $105,000 ÷ $100,000 = 105%.

Answer: The company sells 40 contracts. The futures gain is $105,000, so total receipt is $5,405,000, an effective rate of $1.0810 per €1. The hedge efficiency is 105%. The basis narrowed by 0.0010, from −0.0050 (1.0800 − 1.0850) to −0.0040. Because of this, the futures gain (0.0210 per € hedged) was larger than the spot fall (0.0200), and the effective rate of 1.0810 ended above the opening spot of 1.0800.

Exam tips

Write the rate side next to every number you use. Markers give a mark for the correct bid or offer choice.
Show each step on its own line. In AFM, you can earn method marks even if your arithmetic slips.
Do not stop at the calculation. Compare the methods and give a reasoned recommendation tied to the scenario, because professional skills marks reward commercial judgement.
For futures, state the position (buy or sell), the number of contracts, any rounding, and the effect of the basis. Mention margin requirements as a cash flow issue.
If the question asks for a recommendation on a hedge, mention that a forward and money market hedge fix the outcome, while options or no hedging may allow gains but carry risk. Link to the company's risk appetite.

Practice questions from Management of international trade and finance

Forward Contracts and Money Market Hedges in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Forward Contracts and Money Market Hedges: frequently asked questions

Is a forward contract better than a money market hedge?

It depends on the numbers and on the situation. In theory the two should be close because of interest rate parity. In the exam, calculate both at the same date and choose the better outcome, then add practical points such as simplicity, banking relationships and the company's ability to borrow.

How do I decide whether to borrow or deposit in a money market hedge?

Ask whether you owe foreign currency or will receive it. For a payable, you deposit foreign currency now to build the amount you need. For a receivable, you borrow foreign currency now and repay it from the receipt.

Do I buy or sell futures to hedge a foreign currency receipt?

You sell futures on the currency you will receive. If the currency falls, the loss on the receipt is offset by a gain on the futures. For a payable in the foreign currency, you buy futures.

What does basis mean in currency futures?

Basis is the spot price minus the futures price. It narrows towards zero as the contract nears expiry. If it changes by a different amount from what you expected, the hedge is not perfect, and the effective rate differs from the opening futures price.

Why does my money market hedge differ from the forward rate?

Small differences are normal. They come from bid-offer spreads, different borrowing and deposit rates, and rounding. A large difference usually means you used an annual rate for a part-year period or the wrong side of a quote.