FX Hedging Cost Components

Some spread cost definitions

(For more information on spreads, go to What’s a Spread?)

Interbank Market: A market in which financial institutions can trade. The term refers to foreign exchange markets that are accessible only to banks or financial institutions. There is no physical marketplace; the transactions take place over communication networks.

Interbank FX Spreads: Spreads charged by banks to each other when trading foreign currency in the interbank market. Only some very large multinational companies and some foreign exchange brokers have access to interbank FX spreads. These spreads typically trade at consistent levels except during times of low liquidity (market closes and for the few minutes around major news events such as BOE/Fed interest rate announcements).

Interest Differential or Interest Carry Costs: Each currency has a different interest rate associated with it. You receive interest on the currency you purchased (long), and must pay interest on the currency you sold (short). The difference is the carry or interest differential, sometimes referred to as the cost of carry. All foreign currency transactions (such as futures, forwards and exotics) that settle in the future will have the interest differential cost built into the spread.

Interest risk premium: Interest risk premium is a variable amount charged by the issuing party for potential changes in interest rates which would impact the interest differential for fixed priced FX contracts that settle in the future.

Commissions: Forward contract and option contract suppliers build commissions into their products based on how much they can charge the buyer. The commission is built into the forward rate or included in the amount paid upfront for an option (also called the premium). Sometimes commissions are listed and charged for separately, and often there are multiple commissions involved (for example, a commission for the broker, a commission for the exchange, a prime brokerage commission).

Volatility charge: Options are one-sided contracts that carry an upfront purchase premium Options offer the right, but not the obligation, to engage in a future transaction. An estimate of the future volatility of the foreign currency over the life of the option is built into the option pricing. While an individual option may incur a large payout, other options will expire without being exercised.