Advanced Financial Management · The use of financial derivatives to hedge against forex risk

Forward Contracts and Money Market Hedges for ACCA AFM

Updated 11 October 2026 · Fact-checked

A forward contract fixes the exchange rate today for a future currency payment or receipt. A money market hedge creates the same certainty by borrowing or depositing in the two currencies now and converting at spot. You calculate the home-currency outcome of each and choose the better one: the lower cost for a payable, the higher proceeds for a receivable.

Understand Forward Contracts and Money Market Hedges

A company that will pay or receive foreign currency later does not know today's home-currency value of that cash flow. The exchange rate may move before the date. This is transaction exposure. Hedging fixes the outcome so the finance team can plan.

A forward contract is the simplest tool. You agree with a bank today to buy or sell a set amount of currency on a set future date at a rate fixed today. The bank quotes two rates. It buys the base currency at the lower rate and sells it at the higher rate. You always deal at the rate that is worse for you.

A money market hedge copies the forward contract using deposits and loans. For a payable, you deposit enough foreign currency today so that, with interest, it equals the amount you owe. You buy that currency at spot, funded by home borrowing. For a receivable, you borrow foreign currency today so that, with interest, it equals the amount you will receive. You sell it at spot and deposit the home currency. The foreign receipt then repays the loan.

The two methods give similar answers because of interest rate parity. The forward rate reflects the interest rate gap between the two currencies. The currency with the higher interest rate trades at a forward discount. Small differences remain because banks quote different borrowing and deposit rates and charge spreads. That gap is why the exam asks you to compare the two.

The AFM exam gives you the rates and expects you to do the arithmetic, choose a method, and explain the result. Marks also go for noting risks and practical points. These include credit risk, the need for the cash to be available in the money market method, and the fact that a forward contract is binding even if the underlying deal falls through.

Key rules to remember

Forward rate under interest rate parity: F = S × (1 + i quote currency) ÷ (1 + i base currency); Quote currency is the one the rate is expressed in. For $ per €1, the $ rate goes on top and the € rate below. Use rates for the period, not annual rates, unless the period is one year.
Forward contract: payable: Home cost = foreign amount × forward rate at which the bank sells the foreign currency; Use the higher rate when the rate is quoted as home currency per unit of foreign currency.
Forward contract: receivable: Home proceeds = foreign amount × forward rate at which the bank buys the foreign currency; Use the lower rate when quoted as home currency per unit of foreign currency.
Money market hedge: payable: Deposit today = foreign payable ÷ (1 + foreign deposit rate for the period); Convert at the spot rate at which the bank sells foreign currency. Then compound the home borrowing cost to the payment date, or deposit interest lost if you use cash.
Money market hedge: receivable: Foreign loan today = foreign receivable ÷ (1 + foreign borrowing rate for the period); Convert at the spot rate at which the bank buys foreign currency. Then add home deposit interest to the receipt date.
Period interest rate: Period rate = annual rate × months ÷ 12; Exam questions normally expect simple pro-rating for periods under a year. Follow any instruction in the question.

How to solve Forward Contracts and Money Market Hedges questions

Use the same routine for any forward or money market hedge question. Write the timeline first, because it stops you picking the wrong rate.

1Identify the exposure: payable or receivable, the currency, the amount and the date.
2Note which currency is home and how the rates are quoted (home per foreign or foreign per home). Decide which side of each quote applies to you.
3Forward contract: pick the correct forward rate and multiply to get the home-currency cost or proceeds.
4Money market hedge: list the foreign and home interest rates and convert each to the period rate.
5Money market hedge: work out the foreign amount to deposit (payable) or borrow (receivable) today, using the foreign rate.
6Convert that foreign amount at the correct spot rate, then carry the home amount forward with the home interest rate to the payment date.
7Compare the two outcomes. For a payable choose the lower cost. For a receivable choose the higher proceeds.
8Add a short comment: the difference, any unhedged alternatives you were asked about, and practical points such as credit risk, timing uncertainty or cash availability.

Quickest way: Timeline and side-of-the-quote check

When to use it: Use this when you have limited time and the question is a straightforward comparison of a forward contract and a money market hedge.

Do the forward answer first. It is one multiplication and often earns easy marks.
Write the money market chain as a line: foreign amount ÷ (1 + foreign rate) × spot × (1 + home rate).
For a payable, use the foreign deposit rate, the bank's selling spot rate and the home borrowing rate.
For a receivable, use the foreign borrowing rate, the bank's buying spot rate and the home deposit rate.
Underline the currency units on every line to avoid dividing when you should multiply.
Finish with a one-line recommendation and one practical comment.

Common mistakes in Forward Contracts and Money Market Hedges

Using the wrong side of the bid-offer quote
Students pick the first or second number without thinking about who is buying and who is selling.
Fix: Write who is buying the foreign currency, you or the bank. When the rate is home per foreign, you pay the higher rate to buy and receive the lower rate to sell.
Using the wrong interest rate in the money market hedge
A table of four rates is given and students grab the nearest one.
Fix: Foreign deposit rate for a payable, foreign borrowing rate for a receivable. Then home borrowing rate if you borrow home currency, or home deposit rate if you invest home currency.
Using the annual rate for a part-year period
Students skip the pro-rating step under time pressure.
Fix: Convert to the period rate first: annual rate × months ÷ 12. Write it beside the question before you start.
Multiplying instead of dividing when converting
Quotes can be home per foreign or foreign per home and students lose track of which.
Fix: Check units. If the rate is $ per €, euros × rate gives dollars. If it is € per $, euros ÷ rate gives dollars.
Discounting at the home rate or compounding at the foreign rate
Students mix up which currency the deposit or loan is in.
Fix: The foreign loan or deposit grows or is discounted at the foreign rate. The home borrowing or deposit is compounded at the home rate.
Stopping at the numbers with no recommendation
Students think the calculation is the whole answer.
Fix: State which method is better and by how much. Add one or two points on risk, such as the forward contract being binding or counterparty credit risk. Professional skills marks reward a clear conclusion.

Worked examples

Example 1

A US company (home currency $) must pay a supplier €2,000,000 in six months. Spot rate is $1.0800 to $1.0850 per €1. Six-month forward rate is $1.0900 to $1.0960 per €1. Annual interest rates: euro deposit 3%, euro borrowing 5%, dollar deposit 4%, dollar borrowing 6%. Compare a forward contract with a money market hedge, assuming the company would borrow dollars to fund the hedge.

Show the solution

The company buys euros, so the bank sells euros at the higher rate in each quote: spot $1.0850, forward $1.0960.
Forward contract: €2,000,000 × 1.0960 = $2,192,000.
Money market: six-month euro deposit rate = 3% × 6 ÷ 12 = 1.5%.
Euros to deposit now = 2,000,000 ÷ 1.015 = €1,970,443.
Buy euros at spot: 1,970,443 × 1.0850 = $2,137,931.
Six-month dollar borrowing rate = 6% × 6 ÷ 12 = 3%.
Cost in six months = 2,137,931 × 1.03 = $2,202,069.
Compare: forward $2,192,000 against money market $2,202,069. The forward is cheaper by about $10,069.

Answer: Use the forward contract. It costs $2,192,000, about $10,069 less than the money market hedge at $2,202,069. Both fix the cost, but the forward contract is binding and carries bank credit risk.

Example 2

A US company expects to receive €1,500,000 in three months. Spot rate is $1.0800 to $1.0850 per €1. Three-month forward rate is $1.0820 to $1.0880 per €1. Annual interest rates: euro deposit 3%, euro borrowing 5%, dollar deposit 4%, dollar borrowing 6%. Recommend the better hedge.

Show the solution

The company sells euros, so the bank buys euros at the lower rate in each quote: spot $1.0800, forward $1.0820.
Forward contract: €1,500,000 × 1.0820 = $1,623,000.
Money market: three-month euro borrowing rate = 5% × 3 ÷ 12 = 1.25%.
Euros to borrow now = 1,500,000 ÷ 1.0125 = €1,481,481.
Sell the euros at spot: 1,481,481 × 1.0800 = $1,600,000.
Three-month dollar deposit rate = 4% × 3 ÷ 12 = 1%.
Dollar value in three months = 1,600,000 × 1.01 = $1,616,000.
The euro receipt repays the euro loan, so no exposure remains.
Compare: forward $1,623,000 against money market $1,616,000. The forward gives $7,000 more.

Answer: Use the forward contract. It gives $1,623,000 against $1,616,000 from the money market hedge, a gain of $7,000. Check that the receipt is certain in timing, because a forward contract must be settled even if the customer pays late.

Exam tips

Show every step. A wrong rate choice early can still earn method marks if the working is visible.
Write the rate side you are using, such as bank sells € at 1.0850, next to each calculation.
If the question mentions a date that may change, discuss forward options or extension risk in your comment.
Always finish with a recommendation. Section A professional skills marks reward a clear, justified conclusion.
If asked to explain interest rate parity, link the forward rate to the interest differential and say it holds approximately, not exactly, in practice.

Practice questions from The use of financial derivatives to hedge against forex risk

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

What is the difference between a forward contract and a money market hedge?

A forward contract is an agreement with a bank to exchange currency at a fixed rate on a future date. A money market hedge uses borrowing and deposits in two currencies and spot conversion to lock in the same result. The outcomes are close but not identical because of spreads and different interest rates.

How do I do a money market hedge step by step?

Convert the foreign amount to today's value using the foreign interest rate: deposit for a payable, borrow for a receivable. Convert it at the correct spot rate. Then carry the home amount to the payment date using the home interest rate. Compare the result with the forward outcome.

How does interest rate parity link to forward rates?

The forward rate is the spot rate adjusted for the difference between the two interest rates. The currency with the higher interest rate trades at a forward discount. This is why forward and money market hedges give similar answers.

Which rate do I use for a payable and which for a receivable?

Think about what the bank does. For a payable you buy foreign currency, so the bank sells it to you and you use the less favourable rate for you. For a receivable you sell foreign currency, so the bank buys it and you again use the less favourable rate.