Forward Contracts and Money Market Hedges

The simplest way to remove an exchange rate risk is to agree the rate now. A forward contract does exactly that: the company and its bank agree today the rate at which a stated amount of currency will be exchanged on a stated future date, and neither exchange rate movements nor the company’s luck in guessing them can change the result.

The alternative, the money market hedge, reaches the same place by a different route: the company borrows or deposits foreign currency now so that the foreign currency it will receive or pay later is matched, and converts today at the spot rate.

In theory the two give almost the same effective rate, because both are priced from the same interest rates; in practice, with real bid and offer rates, one will be better, and a company must calculate both.

This topic explains the forward contract (what it is, how to use it for a receipt and a payment, its advantages and limits), how to construct a money market hedge for a receipt and for a payment, how to compare them, and why judging a hedge with hindsight is misleading, with worked examples. The next topic covers currency futures, options and swaps.

The advantages of forward contracts, the amount received under a forward contract and a comparison in hindsight were parts of November Diet, 2025, Question 4 (20 marks). Read internal hedging first.

Hedging with a forward contract

A forward exchange contract is a binding agreement between a customer and a bank to exchange a specified amount of a specified currency on a specified date (or any time within a specified period, an “option” forward) at a rate fixed now. The bank quotes the rate, derived from the spot rate and the interest differential (see the previous topic). For a company the position is:

• A company that will receive foreign currency sells it to the bank forward: the bank buys at the bid rate.
• A company that will pay foreign currency buys it from the bank forward: the bank sells at the offer rate.

1. Spot is ₦1,340 – ₦1,350; the three-month dollar premium is 45 – 50 points, so the forward rates are 1,340 + 45 = 1,385 and 1,350 + 50 = 1,385 – 1,400.
2. The company sells dollars at the bid.
   600,000 × 1,385 = ₦831,000,000, whatever the spot rate is in three months.

Example (payment). An importer will pay $400,000 in six months. With a six-month premium of 95 – 105 points the forward rates are 1,435 – 1,455. The importer buys at the offer: 400,000 × 1,455 = ₦582,000,000.

Advantages and limits of a forward contract

• Advantages: certainty of the home-currency amount, so the margin and cash flow can be planned; no cost to arrange apart from the spread built into the rate and no premium; can be tailored to any amount and date; simple and widely available; removes the need to forecast.
• Limits: it is binding, so the company gives up any favourable movement; it must be completed even if the underlying transaction falls through or is late (then the company must buy or sell at the spot rate to close, with a possible loss); it uses part of the bank credit line; and the rate includes the interest differential, so a currency at a premium costs more forward.

The money market hedge

A money market hedge uses the money markets to create the same effect as a forward contract. The company borrows or deposits so that a foreign currency liability or asset is created now that is equal and opposite to the future exposure, and converts at today’s spot rate. Interest rates are annual rates, so use the rate for the period: annual rate × months ÷ 12. For borrowing use the higher rate, for depositing the lower rate.

A receipt: borrow the foreign currency

The Nigerian exporter will receive $600,000 in three months. Dollar borrowing costs 5.5% a year and the naira deposit rate is 22% a year; spot is ₦1,340 – ₦1,350.

1. Borrow dollars now.
   so that the loan plus interest equals the receipt: interest for three months is 5.5% × 3 ÷ 12 = 1.375%
   amount = 600,000 ÷ 1.01375 = $591,862.
2. Sell the dollars at the bid spot rate.
   of 1,340: 591,862 × 1,340 = ₦793,094,945.
3. Deposit the naira.
   for three months at 22% × 3 ÷ 12 = 5.5%: 793,094,945 × 1.055 = ₦836,715,166 at maturity.
4. In three months the $600,000 received repays the dollar loan.

The effective rate is 836,715,166 ÷ 600,000 = ₦1,394.53 per dollar, better than the forward bid of 1,385: the money market hedge gives ₦5.7 million more (836.7m against 831.0m).

A payment: deposit the foreign currency

The importer will pay $400,000 in six months. The dollar deposit rate is 4.5% a year and the naira borrowing rate 24% a year.

1. Deposit dollars now.
   : interest for six months is 4.5% × 6 ÷ 12 = 2.25%
   amount = 400,000 ÷ 1.0225 = $391,198.
2. Buy the dollars at the offer spot rate.
   of 1,350: 391,198 × 1,350 = ₦528,117,359, financed by a naira loan.
3. Naira loan after six months.
   at 24% × 6 ÷ 12 = 12%: 528,117,359 × 1.12 = ₦591,491,443.
4. In six months the dollar deposit grows to $400,000 and pays the supplier.

The effective rate is 591,491,443 ÷ 400,000 = ₦1,478.73, against the forward offer of 1,455. The forward contract is better, costing ₦582.0m against ₦591.5m, a saving of ₦9.5 million. If the company already holds spare naira, it would use its own cash instead of borrowing, and the opportunity cost is the naira deposit rate.

Comparing the two, and hindsight

The two methods give similar answers when interest rates and forward rates are consistent.

They differ in practice because of the spreads between deposit and borrowing rates and between bid and offer rates, so the exercise is to calculate the home-currency result of each and choose the better one, considering also the effect on the statement of financial position (a money market hedge creates a loan and a deposit), the borrowing capacity used, and the practicalities.

Hindsight. After the event it is easy to compare the hedge with what the spot rate turned out to be. The importer paid ₦582.0m under the forward contract.

If the spot rate after six months was ₦1,430, paying would have cost 400,000 × 1,430 = ₦572.0m, so the hedge cost ₦10.0m more; if the spot rate was ₦1,480, paying would have cost ₦592.0m, and the hedge saved ₦10.0m. Neither comparison shows that the decision was right or wrong.

The purpose of hedging is to remove the uncertainty and protect the margin on the transaction, not to beat the spot rate. The future spot rate could not have been known when the decision was made. Judge a hedge by the information available on the day it was taken and by whether it met the objective.

The ideas in more depth

Why the money market hedge works

A future receipt of $600,000 is, in effect, a dollar asset. Borrowing the present value of it in dollars creates an equal dollar liability that the receipt will repay, so the dollar exposure is gone and the company has the present value in dollars, which it converts to naira at today’s known rate and invests.

It has swapped an uncertain future conversion for a certain one today, and its naira outcome is the naira it ends up with, which depends only on known rates. A forward contract does the same without the borrowing, which is why the two are priced from the same interest rates.

Why the bank’s rates matter

Each step uses the less favourable rate: dollars sold at the bid, bought at the offer; borrowing at the higher rate and depositing at the lower. Using the middle rate would flatter both methods. In an examination, state which rate is used at each step and why.

Sources and references

• Forward contracts and money market hedges are arranged through authorised dealers under the rules of the Central Bank of Nigeria; the rates in the examples are illustrative. International Financial Reporting Standard (IFRS) 9 allows hedge accounting for qualifying hedges of foreign currency exposures.

These points are stated as at 5 November 2026.

Worked examples

1. Naira.
   600,000 × 1,385 = ₦831,000,000.

1. Period rate.
   4.5% × 6 ÷ 12 = 2.25%.
2. Amount.
   400,000 ÷ 1.0225 = $391,198.

1. Rate.
   591,491,443 ÷ 400,000 = ₦1,478.73 per dollar.

How to answer in the exam

• Identify whether it is a receipt or a payment and the rate side the bank will use.
• Show each step of the money market hedge with the period interest rate.
• Compare the home-currency results of the forward and the money market hedge and recommend one.
• Discuss hindsight and the limits of each method if asked.

Common mistakes in the exam

• Using the annual interest rate for a part-year.
• Borrowing foreign currency for a payment, or depositing it for a receipt.
• Using the wrong side of the spot rate or the wrong interest rate.
• Comparing a loan and a deposit at different dates without compounding to the same date.
• Judging a hedge by the spot rate that happened.
• Forgetting that a forward contract is binding.

Quick revision

• Forward: receipt at the bid, payment at the offer; binding; no up-front cost.
• Money market hedge: receipt, borrow foreign currency; payment, deposit foreign currency.
• Period rate = annual rate × months ÷ 12; compare the home-currency outcomes.
• Hindsight does not show a hedge was wrong.

Practice questions

These are original questions written in the style of the Institute’s exams. Try each one before you open the answer. Section A is a recall check, because the paper itself is written.

Recall check: multiple choice

Section B style: written questions

A further written question

Model answers

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