No Free Lunch—Pricing for Derivatives
You’ve done the homework and learned about the main strategies of FX risk mitigation. The next question is: How much will this cost me? Costs can vary widely depending on what derivative is being traded and the nature of the underlying markets. But there are generally two costs: spread and commission.
What’s the Spread?
The spread is the transaction cost based on the bid-ask spread. The bid-ask spread is the difference between the highest price an FX dealer is willing to pay for an asset and the lowest price a dealer is willing to sell. Put another way, the bid is like the wholesale price, and the ask is like the retail price. If you are looking to sell, you will receive the bid price. Conversely, if you are looking to buy, you will pay the ask price. It is in your best interest to have the narrowest possible spread. A narrow spread means you pay less to enter and exit the market.
A broad rule that applies to all financial instruments is that the higher the trading volume, the narrower the bid-ask spread. Higher volume usually translates to a more competitive marketplace. In the FX world, the pairs with the highest trading volume and tightest spreads are called the major pairs. The major pairs include the biggest industrialized countries paired with the U.S. dollar: EURUSD, GBPUSD, USDCHF, USDCAD, AUDUSD, and USDJPY. The trade volumes of these pairs measure in hundreds of billions per day. Whether you’re looking at forwards, options, or futures, derivatives with the most significant trading volume tend to have the tightest spreads.
Whether you’re looking at forwards, options, or futures, derivatives with the most significant trading volume tend to have the tightest spreads.
- Euro (EUR)
- Canadian dollar (CAD)
- Japanese yen (JPY)
- British pound (GBP)
- Australian dollar (AUD)
- Swiss franc (CHF)
Major Currency Pairs With Normal Spreads (in Pips) for Spot Transactions*
- EURUSD 1.3
- GBPUSD 2.2
- USDCHF 1.9
- USDCAD 3.0
- AUDUSD 1.9
- USDJPY 1.4
Commissions vary and depend on the product and whether it is exchange-traded or over-the-counter.
- Exchange-traded futures and options are accessed through a broker who is a member of the exchange. Commissions vary from broker to broker, so shopping around will help you get the best rate. Executions of exchange-traded derivatives will also be subject to exchange fees.
- Over-the-Counter (OTC) forwards are private transactions between two parties, and the commissions are negotiated between the two parties. Often the commission is built into the price quoted for the forward contract.
Today’s marketplace is highly transparent and competitive, so execution costs should not vary much from broker to broker. Because OTC forwards are not regulated by an exchange, it is imperative that you use a reputable and trusted broker.
Many considerations factor into the cost of hedging. The first step is performing a thorough analysis of your FX exposure. An in-depth look will help you decide on the most cost-effective strategy and products.
- Two costs are associated with derivatives: spread and commission.
- The spread cost is based on the bid-ask spread. The narrower the spread, the lower the cost.
- Larger trading volumes lend to lower costs. The major pairs have the most significant trading volume.
- Commissions will vary depending on whether it is exchange-traded or over-the-counter.
* Spreads quoted by Forex.com on 10/19/22
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