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Hot Money

Updated on April 22, 2024
Article byWallstreetmojo Team
Edited byAshish Kumar Srivastav
Reviewed byDheeraj Vaidya, CFA, FRM

Hot Money Meaning

Hot money refers to the portfolio of funds actively invested in diversified assets (stocks, deposits, bonds, commodities currencies, and derivatives) intending to take advantage of any available short-term opportunity to earn higher short-term returns. This type of investment results in frequent movement of money between countries, and so the money only stays in one place for a year or even much less than that.

Hot Money Meaning

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Thus, is is the currency that very swiftly moves between various financial markets. It tends to moves towards economies that give higher interest rates. Banks of an economy try to bring these funds by issuing certificate of deposits for short term bearing higher interest rates.

Key Takeaways

  • Hot money refers to funds that are actively invested in various asset classes, such as stocks, deposits, bonds, commodities, currencies, and derivatives. 
  • The objective of hot money is to capitalize on short-term opportunities to generate higher returns within a short period.
  • Hot money investments involve frequent buying and selling of assets, including currency exchanges. As a result, the funds tend to move quickly between different locations and may not remain in one place for a significant period, often less than a year.
  • The primary goal of hot money investors is to maximize profits as quickly as possible. 

Hot Money Explained

Hot money is an investment strategy that entails the movement of capital from one economy to another to take advantage of short-term opportunities.

Financial institutions, such as banks, lure hot money investors by introducing certificates of deposit that offer an above-average rate of interest. As soon as a bank cuts its interest rates while another bank increases its interest rates, these investors withdraw their funds from the bank with a lower interest rate and move it to the bank with a higher interest rate.

The same concept of hot money flows can also be extended to economies wherein these investors move their funds from one country to another to take advantage of the favorable interest rate differentials.

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Purpose

  • The purpose of hot money inflows is straight and simple – to make money as soon as possible and as much as possible. Investors pursuing such a strategy don’t intend to wait for weeks or years for the investment return.
  • These investments warrant active participation and regular monitoring of the investment portfolio. So, these investors always keep track of what is happening in the market to ensure that their investments are going strong at all times.
  • In case of any signal of a market dip, these investors are one of the early movers who place their money elsewhere to avoid any diminution of investment.

Example

Let us look at some examples of hot money.

  • Let us take the example of US 3-month Treasury bills and British 3-month LIBOR to illustrate this concept. Let us assume that at present, there is a negative interest rate environment in the US (3-month Treasury bills is 1.50%) due to various geopolitical issues, while the situation is stable in UK where the 3-month LIBOR is 1.80%.
  • So, the investors with hot money flows who hold funds in any US bank will move the funds to some bank based in the UK, seeking an interest rate of 1.80% in the British market. The investment might be in the form of certificates of deposit or other short-term debt instruments.
  • Again, let us assume that there is a change in the market and the US government decides to increase the 3-month Treasury bill rate to 1.95%. In this case, these investors will convert their pounds to US dollars and invest their funds in a US-based bank. This example aptly captures the unreliable nature of this investment strategy.

Thus, the above examples of hot money explain the concept very clearly.

Types

Although all types of hot money capital exhibit the same common characteristics – short investment horizon and frequent movement, they can still be categorized under two major heads based on the form of investment:

  1. Short-term investment portfolio in a foreign country
  2. A short-term loan in a foreign bank
Hot Money

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Risks

Given the short-term nature, along with high returns, there are bound to be some risks associated with hot money investment, and it is important to know about these risks. Some of the major risks of hot money inflows are:

  1. Volatile Nature: This investment strategy exploits market volatility to generate quick and high returns. However, such a strategy comes at the cost of high investment risk, which is that it might result in a large number of losses in no time.
  2. Transaction Costs: Such high-frequency trading means a large number of transactions that entail high costs. The transaction costs can eventually devour any potential returns generated by the investment portfolio.

Investing In Hot Money

As discussed in the previous section, the hot money inflows investment strategy isn’t for the faint-hearted investors. This strategy requires market knowledge, financial intelligence, and luck. However, investors can follow two cents of advice to increase their chances of success with hot money:

  1. Conduct Research: It is always advisable to gather as much information as possible before starting an investment. Quality information is often seen to be the difference between a smart trader and a reckless investor.
  2. Start Small: It is better to start small while starting with a new investment strategy. It helps in abating the risk of large losses at the start. One can always go big after becoming the master of the trade.

Effects

The hot money often results in economic and financial consequences on countries. The economy in which the funds are pumped gain in terms of the value of their currency, and the exchange rate goes up, while the economy from which there are hot money outflow suffers from a weakening currency and so lower exchange rate.

Importance

Some importance of hot money outflow and inflow are as follows.

  • It can significantly influence the exchange rate and flow of capital in a country.
  • It can flood short-term liquidity into a country, which may result in inflation or asset overvaluation.

Frequently Asked Questions (FAQs)

1. Is FII hot money?

Foreign Institutional Investors (FIIs) can be considered a form of hot money. FIIs are institutional investors who invest in a country’s financial markets other than their own. Their investments can be relatively short-term, and they often seek quick returns. However, it’s important to note that not all FII investments are considered hot money, as some FIIs may take a long-term investment approach.

2. What are the causes of hot money? 

Various factors, including interest rate differentials, exchange rate fluctuations, economic and political instability, and market speculation, can cause hot money flows. Higher interest rates in one country compared to others can attract short-term investments seeking better returns. Similarly, changes in exchange rates or economic conditions can create opportunities for quick profits, attracting hot money flows.

3. What is the difference between hard money and hot money? 

Hard money refers to funds that are invested for a longer-term period and with a more stable outlook. It typically involves longer-term investments in tangible assets such as real estate or physical commodities. On the other hand, hot money refers to short-term funds that are actively invested across various asset classes, aiming for quick returns by capitalizing on short-term opportunities. 

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