How Carry Spot Trading Guarantees Future Cost Certainty

A Hedging Scenario

This scenario uses a carry spot trade to hedge out a U.S. company’s exposure to a future purchase from Germany.

• The Scenario
• The Hedge
• Hedging Costs
• Maintaining Margins

The Scenario

Assume that a U.S. company enters into a contract to purchase a 100,000 euro machine from a German company with an expected delivery date in eight months. The company would like to obtain cost certainty
on this future amount, to be paid in U.S. dollars.
A hedge is not about making money. A hedge is about obtaining certainty on the cost of your German machine. Let's start with the cost of the machine today. A (100,000) euro payable would cost 157,000 U.S. dollars today, assuming a current EUR/USD exchange rate of 1.57000.

The Hedge

If you enter into a buy 100,000 EUR/USD carry spot trade on an online forex broker’s system, then you will receive cost certainty in eight months. Here’s how:
When you enter into the “Buy” transaction for 100,000 EUR/USD carry spot trade, you have bought 100,000 Euros and sold 157,000 USD on an online forex broker’s system.

• If in the future, the EUR/USD price is 1.60 (up from 1.57 when first entered into the deal), then you will have made $3,000 on your forex hedge trade. When you make the payment to the German supplier, the 100,000 euro would cost you 160,000 USD. So your net cost for the machine would be $157,000. (The actual cash payment to the German supplier of $160,000, less the $3,000 made on the hedging trade.)
• If in the future, the EUR/USD price is 1.50 (down from 1.57), then you will have lost $(7,000) on your forex hedge trade. When you make the payment to the German supplier, the 100,000 euro would cost you 150,000 USD. So your net cost for the machine would still be $157,000. (The actual cash payment to the German supplier of $150,000, plus the $7,000 lost on the hedging trade.)

The hedge trade’s win or loss is offset by the actual amount of money paid to the German supplier. With a simple hedge, you have created cost certainty for your company.
The hedging performance must be evaluated based on the overall result. (What is the total machine cost when you make the final payment? This is the combination of the actual USD amount needed to buy the 100,000 euros in eight months and the amount lost or gained on the hedge trade.)
The amounts in this scenario would equal the $157,000 USD, which was your cost certainty objective. With a hedge, you do not need to be concerned with whether you are making or losing money on currency fluctations in the time period between when you sign a purchase agreement and finally take possession of the German machine.

Hedging Costs

A hedge will cost money, similar to an insurance cost. For example, with a carry spot trade you will incur interest carry costs and hedge costs. The following cost summaries use the above scenario,

Interest carry costs:

1. You will be earning interest on the 100,000 EUR you purchased, which will be converted to U.S. dollars (that is, you will earn $4029.67 on interest, assuming a current interest rate of 3.85% on 100,000 euros multiplied at the current exchange rate of 1.57).
2. You will be paying 3.90% on the 157,000 USD sold (a short position), for an interest charge of $4082.
3. If current interest rates and exchange rates held for the next eight months, the cost would be approximately $4029.67 - 4082 = (52.33), the difference between the interest earned on the euros purchased and the interest expense on the US. dollars sold).

Interest carry costs are minimal in this scenario, but this may not always be the case depending on the interest rates being charged for the currencies bought and sold, both now and in the future. Sometimes you will make money on the interest carry costs and sometimes it will cost money. Actual interest carry costs will fluctuate with changing interest rates and changing foreign exchange rates over time.

Hedge costs:

Hedge costs are the difference in price between buying and selling the hedge, known as the spread. Assuming a spread of 4 pips, the cost would be $40.

Total cost to hedge:

If interest rates stay the same over the next eight months, the overall hedge cost would be approximately $95 USD (the interest carry cost plus the hedge costs), or 9.5 pips of the purchase price. This would be similar to a future or forward rate of 1.57095.
This $95 cost is the amount you pay to ensure that you obtain cost certainty on the price of the German machine.

Maintaining Margins

If you use an online forex broker for carry spot trades, you need to deposit margin dollars. (Retail forex brokers are not authorized by regulation to offer customer credit, so margins are always required.) A couple things to remember regarding margin accounts:

• Maintain at least 8 to 10 percent margin coverage for future exchange rate fluctuations. Exchange rates have been quite volatile recently, so a higher amount of margin is recommended to handle swings in currency movements. (In the above scenario, a ten percent margin coverage would be approximately $15,700 USD.)
• You must monitor the margin account balance regularly. You may find that you will need to add margin dollars to prevent a margin call or you may have excess margin dollars in your account that you may withdraw. A margin call on your trade would terminate your hedging position, thereby removing your cost certainty. (The worst case for the above scenario would be a reduction in the EUR/USD rate that triggers a margin call, then a rapid increase in the rate after you no longer have your hedge. In this scenario, you would end up paying more.)
• Your margin amount will be returned to you when your hedge is finished (plus/minus any money made/lost on the hedging trade, the interest carry costs and the interest earned on the margin amount, of course). Because this is your money, ensure your online forex broker is paying competitive interest on your margin account and has competitive interest rates on the currencies bought and sold. And make sure your funds are secure—evaluate your counterparty risk.

Remember, hedging is not about making money on the hedge transaction. Hedging is about creating cost or revenue certainty. You are locking in the future exchange rate for a certain future forex transaction.