What is Hot Money?

Purpose of Hot Money

  • The purp

  • 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 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.

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How does it Work?

  • Financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more, 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 billsTreasury BillsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more 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 depositCertificates Of DepositA certificate of deposit (CD) is an investment instrument mostly issued by banks, requiring investors to lock in funds for a fixed term to earn high returns. CDs essentially require investors to set aside their savings and leave them untouched for a fixed period.read more or other short-term debt instrumentsDebt InstrumentsDebt instruments provide finance for the company’s growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans.read more.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.

Types

Although all types of hot money capital exhibit the same common characteristics – short investment horizonInvestment HorizonThe term “investment horizon” refers to the amount of time an investor is expected to hold an investment portfolio or a security before selling it. Depending on the need for funds and risk appetite, the investor may invest for a few days or hours to a few years or decades.read more 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 countryA short-term loan in a foreign bank

Risks Involved

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 tradingHigh-frequency TradingHigh-Frequency Trading is a specific type of trading enabled by technology that makes transactions so fast that they take milliseconds.read more 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 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.

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 the fund exited suffers from a weakening currency and so lower exchange rate.

Importance

  • 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.

Conclusion

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 –

  • DemonetizationForeign Direct InvestmentForeign InvestmentForeign Exchange Risks