What is Hot Money?
Hot money refers to the portfolio of funds that are actively invested in diversified assets (stocks, deposits, bonds, commodities currencies, and derivatives) with the intention 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 hardly stays in one place for more than a year or even much less than that.
Purpose of Hot Money
- The purpose is straight and simple – to make money as soon as possible and as much as possible. The investors who pursue such a strategy don’t intend to wait for weeks or years for the investment return.
- These investment warrants 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.
How does it Work?
- 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 can also be extended to economies wherein these investors move their funds from one country to another country in order to take advantage of the favorable interest rate differentials.
Hot Money Example
- 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 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.
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:
- Short-term investment portfolio in a foreign country
- Short-term loan in a foreign bank
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 are:
- 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.
- Transaction Costs: Such high-frequency trading means a large number of transactions that entail significant 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 strategy of hot money investment isn’t for the faint-hearted investors. This strategy requires a mix of market knowledge, financial intelligence, and luck. However, the investors can follow two cents of advice to increase their chances of success with hot money:
- 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.
- 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.
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 the fund exited suffers from a weakening currency and so lower exchange rate.
- 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.
So, it can be seen that hot money is an investment strategy that entails the movement of capital from one economy to another to take advantage of short-term opportunities.
This has been a guide to What is Hot Money & its Definition. Here we discuss the purpose of hot money, examples, types, and how it works along with risks, effects, and importance. You can learn more about from the following articles –