Definition - What does Hot Money mean?
Hot money refers to the liquid funds from investors with little tolerance for low returns or lack of results on the part of investment managers, in the short run, and that are withdrawn swiftly at any initial signs of trouble. Those who invest hot money tend to move swiftly from one country to another or from one business to another. This is usually done in order to avoid the risk of impending depreciation in value, to take advantage of higher interest rates, or to maximize short-term returns.
Hot money flow plays a crucial role in determining the exchange rates of currencies as the flows also affect the balance of payments in certain countries. International investors may make substantial gains by moving and redeploying their funds in a strategic manner. Business owners should be careful of accepting such funds.
Divestopedia explains Hot Money
The implications of hot money can be best explained by using an example. Let's consider an instance where both Australia and the United States have an interest rate of 0.5%. Australia later increases its rate of interest to 1.5%. A global investor would now get a higher rate of return by moving his or her funds to Australian banks. In response, hot money will flow from the U.S. to Australia, allowing investors to take advantage of higher interest rates in Australian banks.This increased demand for Australian dollars will push up the exchange rate for Australian dollars, compared to U.S. currency.
Similarly, when the U.S. Federal Reserve introduces a bond buying program to increase bond prices, it reduces the yield on bonds. A global investor will sell his or her U.S. bonds and buy assets in emerging markets, such as Turkey and India. Later on, when the Federal Reserve reverses the policy and stops or reduces bond purchases, the U.S. bond yield will go up. In response, investors sell assets in emerging markets to take advantage of the higher bond yield in the U.S. This causes turbulence in emerging markets, as some of them face the risk of depreciation in their home currencies. Therefore, the flow of hot money has profound economic implications for interest rates and balance of payment issues in most countries, emerging markets in particular.
Businesses in the mid-market segment need to keep hot money investors at arm's length as they tend to desert the business at the very first sign of adversity. As a general rule, business owners must choose investors carefully by conducting reverse due diligence on incumbent investors to ensure they will continue to support the company, even if the situation gets tough and challenging.