Strategic Financial Management · Foreign Exchange Risk Management

Forward Contracts and Money Market Hedge Explained

Updated 11 October 2026 · Fact-checked

A forward contract fixes today the rate at which you will buy or sell foreign currency on a future date. A money market hedge does the same job by borrowing or depositing in each currency now. To solve, compute the rupee value at the due date under each method and pick the better one.

Understand Forward Contracts and Money Market Hedge

When an Indian firm will receive or pay foreign currency later, the rupee amount is uncertain. If you are an exporter and the dollar falls, you receive fewer rupees. If you are an importer and the dollar rises, you pay more rupees. Hedging removes this uncertainty.

A forward contract is an agreement with a bank to sell or buy a fixed amount of foreign currency at a fixed rate on a fixed future date. The rate is set today, so the rupee cash flow is known. The forward rate is not a forecast. It comes from the spot rate and the interest rate difference between the two currencies.

A money market hedge builds the same result using loans and deposits. For a receivable, you borrow the foreign currency today, convert it to rupees at spot, and invest the rupees. When the customer pays, the foreign receipt repays your loan. For a payable, you convert rupees to foreign currency at spot today, deposit it, and let it grow to the amount you owe.

The key idea is to move the whole transaction to today. You borrow or deposit the present value of the foreign amount, so that principal plus interest equals the foreign amount at the due date. Then you carry the rupee side forward to the same date and compare it with the forward outcome.

If interest rate parity holds exactly, both methods give almost the same result. In exam questions the quoted forward rate and the borrowing and deposit rates differ, so one method wins. You show both numbers and recommend the better one.

Key rules to remember

Forward rate from interest rate parity: F = S × (1 + r(INR) × t) ÷ (1 + r(FC) × t); S and F are in ₹ per unit of foreign currency. t is in years. Simple interest is used unless the question says otherwise.
Annualised forward premium or discount: (F − S) ÷ S × (12 ÷ n) × 100; n is the number of months. A positive result is a premium. A negative result is a discount.
Forward hedge: receivable: ₹ received = Foreign amount × forward BID rate; The bank buys foreign currency from you, so it uses the lower rate of the two-way quote.
Forward hedge: payable: ₹ paid = Foreign amount × forward ASK rate; The bank sells foreign currency to you, so it uses the higher rate of the two-way quote.
Money market hedge: receivable: Borrow FC amount ÷ (1 + r(FC borrow) × t). Sell at spot BID. ₹ at due date = proceeds × (1 + r(INR deposit) × t); If the firm has INR debt, use the INR borrowing rate, since repaying that debt is the saving.
Money market hedge: payable: Deposit FC amount ÷ (1 + r(FC deposit) × t). Buy at spot ASK. ₹ at due date = cost × (1 + r(INR borrow) × t); If the firm has surplus cash, use the INR deposit rate, the interest it gives up.
Quote rule: Bank buys foreign currency at BID. Bank sells foreign currency at ASK.; Always read the quote from the bank's side.

How to solve Forward Contracts and Money Market Hedge questions

Use this order for any forward or money market hedge question. Keep every figure on the due date so the comparison is fair.

1Identify the exposure: receivable or payable, the currency, the amount and the months to the due date.
2Write the quotes. Mark which side of the two-way quote applies: bid for a receivable, ask for a payable.
3Forward hedge: multiply the foreign amount by the correct forward rate to get the rupee amount on the due date.
4Money market hedge: find the present value of the foreign amount using the foreign interest rate for the period. Use the borrowing rate for a receivable and the deposit rate for a payable.
5Convert that present value to rupees at the correct spot rate: bid when selling foreign currency, ask when buying it.
6Carry the rupee amount to the due date. Use the INR deposit rate if the money is invested, or the INR borrowing rate if it is financed by a loan.
7Compare the two rupee figures on the due date. For a receivable, the higher is better. For a payable, the lower is better.
8State the recommendation and the rupee difference. Add any assumption, such as simple interest or pro-rata annual rates.

Quickest way: Receivable or payable: five-line comparison

When to use it: Use when the question gives a two-way spot and forward quote with four interest rates and asks which hedge is better.

Write R or P at the top. R means bank buys at bid. P means bank sells at ask.
Forward answer first: amount × forward rate. It takes one line.
Divide the amount by (1 + foreign rate × t). Pick the borrow rate for R and the deposit rate for P.
Multiply by spot, then by (1 + INR rate × t), in one chain.
Compare, circle the better method, and write the difference. Use direction words: higher for R, lower for P.

Common mistakes in Forward Contracts and Money Market Hedge

Using the wrong side of the two-way quote, for example the ask rate for an export receivable.
Students read the quote from their own side, not the bank's side.
Fix: Remember that the bank always gains from the spread. For a receivable it buys at the lower rate (bid). For a payable it sells at the higher rate (ask).
Using annual interest rates without scaling them for the period.
The rate is quoted per annum and the question's period is 3 or 6 months, so students forget to pro-rate.
Fix: Multiply each annual rate by months ÷ 12 before using it in any formula.
Borrowing the full foreign amount in the receivable money market hedge instead of its present value.
Students forget that the loan grows with interest until the due date.
Fix: Borrow FC amount ÷ (1 + r × t), so that the loan with interest equals the receipt exactly.
Using the foreign interest rate on the rupee leg, or the reverse.
There are four rates in the question and they get mixed up.
Fix: Label them: FC borrow, FC deposit, INR borrow, INR deposit. The foreign leg uses FC rates and the rupee leg uses INR rates.
Comparing a rupee amount today with a rupee amount at the due date.
The money market hedge gives a rupee figure at spot, so students stop there.
Fix: Carry it forward to the due date at the INR rate before comparing with the forward result.
Giving the two figures but no recommendation.
Students treat it as a pure calculation.
Fix: End with one sentence: which method, and by how many rupees it is better.

Worked examples

Example 1

An Indian exporter will receive USD 2,00,000 in 3 months. Spot rate: ₹83.20 / ₹83.40 per USD. 3-month forward: ₹83.60 / ₹83.90. USD interest rates per annum: borrow 6%, deposit 4%. INR interest rates per annum: borrow 10%, deposit 7%. The exporter has no INR borrowings. Which hedge gives the higher rupee receipt?

Show the solution

The exposure is a receivable, so the bank buys USD at bid. Spot bid is ₹83.20 and forward bid is ₹83.60. Period is 3 months, so t = 0.25.
Forward hedge: 2,00,000 × 83.60 = ₹1,67,20,000.
Money market hedge. USD borrowing rate for 3 months = 6% × 3/12 = 1.5%.
USD to borrow now = 2,00,000 ÷ 1.015 = USD 1,97,044.33. With interest this grows to USD 2,00,000, which the customer's payment will repay.
Sell at spot bid: 1,97,044.33 × 83.20 = ₹1,63,94,089 (rounded).
Invest in rupees. INR deposit rate for 3 months = 7% × 3/12 = 1.75%. Value at due date = 1,63,94,089 × 1.0175 = ₹1,66,80,985 (rounded).
Compare: forward ₹1,67,20,000 against money market ₹1,66,80,985. The forward is higher by about ₹39,015.

Answer: Choose the forward contract. It gives ₹1,67,20,000, about ₹39,015 more than the money market hedge (₹1,66,80,985). This assumes simple interest and no INR borrowings.

Example 2

An Indian importer must pay USD 1,50,000 in 6 months. Spot rate: ₹83.20 / ₹83.40 per USD. 6-month forward: ₹83.90 / ₹84.30. USD interest rates per annum: borrow 6%, deposit 4%. INR interest rates per annum: borrow 10%, deposit 7%. The importer would finance any spot purchase by borrowing rupees. Which hedge costs less?

Show the solution

The exposure is a payable, so the bank sells USD at ask. Spot ask is ₹83.40 and forward ask is ₹84.30. Period is 6 months, so t = 0.5.
Forward hedge: 1,50,000 × 84.30 = ₹1,26,45,000.
Money market hedge. USD deposit rate for 6 months = 4% × 6/12 = 2%.
USD to buy and deposit now = 1,50,000 ÷ 1.02 = USD 1,47,058.82. With interest this becomes USD 1,50,000 at the due date.
Buy at spot ask: 1,47,058.82 × 83.40 = ₹1,22,64,706 (rounded).
The importer finances this by borrowing rupees. INR borrowing rate for 6 months = 10% × 6/12 = 5%. Rupee cost at due date = 1,22,64,706 × 1.05 = ₹1,28,77,941 (rounded).
Compare: forward ₹1,26,45,000 against money market ₹1,28,77,941. The forward costs less by about ₹2,32,941.

Answer: Choose the forward contract. It costs ₹1,26,45,000, about ₹2,32,941 less than the money market hedge (₹1,28,77,941). This assumes simple interest and that the spot purchase is financed by rupee borrowing.

Exam tips

Write R or P and the bid or ask choice before any calculation. This one habit prevents the most common loss of marks.
State your assumptions in one line: simple interest, annual rates pro-rated, which INR rate you used and why.
Show the foreign amount borrowed or deposited as a separate line. The examiner awards marks for the present value step.
In MCQs, the forward result is quick to compute. Check whether the options match it before doing the full money market chain.
Always close with a recommendation and the rupee difference. In a written answer this is usually a separate mark.

Practice questions from Foreign Exchange Risk Management

Forward Contracts and Money Market Hedge 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 Hedge: frequently asked questions

When should I use the money market hedge instead of a forward contract?

Use whichever gives the better rupee result at the due date. A money market hedge is useful when no forward is available for that maturity, or when the interest rates make it cheaper. In a numerical, you must compute both and compare.

Which interest rate do I use in the money market hedge for a receivable?

Use the foreign currency borrowing rate to find the amount to borrow. Then use the INR deposit rate if the rupees are invested. If the firm has INR debt, use the INR borrowing rate, since repaying that debt is the saving.

Why does the bank use bid for receivables and ask for payables?

The bank quotes from its own side. It buys foreign currency at the lower bid rate and sells it at the higher ask rate. An exporter selling dollars gets the bid, and an importer buying dollars pays the ask.

Should I use simple or compound interest in these problems?

Use simple interest pro-rated for the period unless the question says otherwise. For periods of a year or less this is the usual convention in exam questions. State the assumption in your answer.