Hot money refers to the cash that investors from foreign countries will invest during the short term in search of the highest interest rate possible. Normally, you do this through term deposits or certificates of deposit (CDs).
Hot money flows usually occur when one country can provide a higher interest rate than the one where the investor currently lives or conducts business. Often times these investors will invest in short term deposits like CDs. Then they will jump the funds from bank to bank if they can obtain a higher interest rate. Sometimes they will even do this if there is a penalty involved in withdrawing the funds like in a CD. This would only occur if the interest rate at another institution were dramatically higher to cover the cost of withdrawing the funds.
Kawahonda is a hot money investor from Japan and is looking to aggressively invest $100,000 he currently has sitting in a savings account in Japan earning 1%. He begins looking in the United States, and finds that he can earn 5% in short term CDs. He immediately contacts a bank in the United States and deposits the $100,000 in a 3 month CD. There is a 1% penalty if Kawahonda were to withdraw his funds early. After a month invested in the CD Kawahonda finds another bank in the U.S. that offers a CD that pays 8%. Kawahonda immediately withdraws the $100,000 and invest the money in a 6 month CD. at the end of the six month period Kawahonda will have earned:
$100,000 +($100,000 * 1/12 *.05) = $100,417 = amount earned in original CD
$100,417 – ($100,000 *.01) = $99,417 = amount after penalty is assessed
99,417 + ($99,417 * 6/12 * .08) = 103,394 = amount earned in 8% CD
Note: By investing in the higher interest paying CD Kawahonda is able to make $2,144($103,394 – $101,250) more even with the penalty. It is also $2,894 ($103,394 – $100,500) more than if Kawahonda kept is money in his savings account domestically.