What’s a Carry Spot Trade for Hedging?

A Hedging Product Alternative

A typical forex spot trade settles within two business days, at which time the traded currencies are delivered to the respective parties.

A carry spot trade, on the other hand, gives the benefit of competitive spot forex rates without any specified delivery date. A carry spot trade may close at any time on any day (within the same day, or next week or even next year).

When you open a carry spot trade, you are simultaneously buying one currency and selling another. Until the trade is closed (settled), your account will be charged the interest differential on the open position. You will be charged interest on the currency sold and you will earn interest on the currency purchased. It’s important, therefore, to verify that your online forex broker is offering competitive interest rates.

A carry sport trade is different from a currency forward contract, which is a negotiated agreement between two parties to exchange specific amounts of currency at a set rate on a particular day. The forward rate is priced based on the current exchange rate, the interest differential for the contract time, a cost to cover potential negative changes to the interest risk differential, and a flexible built-in commission for the forward contract provider. You will pay for the interest differential or interest carry costs on a forward contract (similar to a carry spot trade). This cost is factored into the forward exchange rate on the forex contract. Ultimately, you are always paying the interest differential or interest carry cost for foreign currency hedging products.

What are the benefits of carry spot trading hedging?

1. You can purchase the exact amount you need to hedge;
2. Your carry spot trade has no expiry date. There's no need to guess when the receivable will arrive, or when the payment must be made.
3. You can change the hedge amount at any time (either add to the forex hedge at current rates or reduce the forex hedge amount).
4. You can terminate part or all of the hedge at any time.
5. Depending on the online forex broker you choose, you will generally pay lower spreads.
6. The interest differential (carry cost) is charged separately, which makes forex hedge accounting easier to administer.
7. There is no mark-up on the interest differential for carry spot trades. In contrast, the spread offered for forex forwards and forex options may include a buried mark-up on the interest differential or a built in commission for the forward/option provider.

Use the Hedging Cost Comparison Tool (Forward Contracts vs. Carry Spot Trades) to find out how you can save money on carry spot hedging.

Things to watch out for with carry spot trades

Not all banks or alternative forex brokers offer the same deal.

Check the spreads. Tight currency spreads between the sell and buy rates on currency pairs lowers the cost of forex risk management. Some online forex brokers offer more competitive rates than others, so it’s important to shop around. Ensure that you are not paying extra spreads or commissions. Watch out for bait and switch rates or teaser rates. Under the classic bait and switch, the rate displayed on the site is for "very large transactions", your transaction rate may not be as competitive.

Insist on flexible hedge amounts. It’s easier to hedge an exact amount of your choosing to avoid over- or under- hedging your forex exposures, so insist on an forex hedge provider that offers flexibility in the amount you can hedge . For example, ensure you are not restricted to hedging specific amounts like 100,000 or 10,000. Exact forex hedging enables you to update your hedge each day, week, or month. You can add more to your existing hedge or close a portion out to ensure that the notional value of your forex hedge always matches the recorded net foreign currency asset/liability exposure.

Ensure flexible expiry dates. Carry spot trades do not have expiry dates. If you collect the foreign currency receivable earlier or later than anticipated, no additional work is required. Conversely, with forex forward contracts, you have to contact your provider to sell the contract early or extend it, likely at a cost.

Avoid counter-party risk. Ensure you are using a reputable and competitive forex broker, preferably regulated. For example, U.S. brokers should be registered by the Commodity Futures Trading Commission (CFTC) and be members of the National Futures Association. Make sure you examine the broker’s excess regulatory capital (which must be reported monthly to the CFTC). Historical reports provide an indication of profitability and/or ability to raise capital. At a minimum, the excess regulated capital will need to satisfy your credit assessment. For example, your company may set a policy that the minimum excess regulated capital requirement for an online forex broker must be in excess of $50 million.

The information is available at the CFTC web site.

Know your costs

When you use a spot trade to hedge future forex exposure transactions, the effectiveness of the hedge is easy to calculate (basically, the dollar offset amount). The change in the value of the future foreign contract equals the change in the value of the forex hedge. The interest differential is charged directly to you over the life of the forex hedge.

If you’ve been managing your forex risk through a major bank, take this opportunity to gain a greater understanding of forex hedging alternatives. Your increased knowledge will also increase your bargaining ability when forex hedging through your bank, and will ultimately lower your costs.

Best of all, today's hedging alternatives have never been cheaper thanks to the Internet, technology advances, and competitive forex margins.