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Spread Betting Finance Costs Explained Financial spread betting is a simple and straightforward way of trading global markets. Among other advantages, leverage stands out as one of the most powerful tools deriving
from spread betting. To get exposure to any market, you just need a small margin of the total trade’s value. You trade on margin and borrow funds from your provider (or lend him when short selling). That way you can commit to trading just a fraction of your total funds and apply the remainder elsewhere. Since there is no such thing as a free lunch, you will have to pay for the borrowed funds you will get. Your provider will charge you a finance cost to rollover your open positions overnight and keep them opened. This fee is called finance cost, and is also known or referred to as overnight cost, rollover cost, or even holding cost. Most of the time these terms refer to the same thing.
——————————————————————The Composition of the Finance Cost The finance cost in spread betting is formed of two basic components: •
Borrowing Cost – the cost of using leverage to trade. You borrow funds from your provider that will require you to pay for it. Using the same reasoning, when you engage in a short position you lend money and will also be paid for that. Carrying Cost – the cost associated with the possession of most commodities. When you buy oil, you are buying a future delivery of X number of barrels. You own the barrels between the time you buy and the delivery date (or until you sell) and you should be responsible for costs that include storage, delivery, and maintenance. Basically, you have to pay for costs of possession.
How to Calculate the Borrowing Cost The borrowing cost is calculated as follows:
(Notional Size of Position – initial Margin Requirement) X Applicable Interest Rate / Day Basis) The notional size of position is the amount you would need if you were to buy a similar position in the market. It is calculated in a simple way: (Closing Price / Unit Risk) X Stake The best is to use an example to explain how it works and better understand the dynamics behind the calculation. Let’s consider you buy the FTSE 100 index at 6,000 points. Your spread betting provider states that stakes on FTSE are per point movement, and you decide to put £10. The unit risk is 1, and the notional size of this position is £60,000. If instead, you were trading the EUR/USD pair the unit risk would be 0.0001 instead. Let’s now look again at the borrowing cost calculation. The first part of it, in parenthesis, represents the total borrowed funds. Assuming your provider requires a margin of 60 points, you will have to deposit in your account £600 to proceed with the trade. You are borrowing £59,400. The second part of the calculation reflects the daily applicable interest rate (dAIR). Providers usually use Libor plus or minus a spread, depending if you are long or short. The daily basis depends on currency conventions and is determined outside the provider like the Libor rate. Depending on the currency, that number would be 360 or 365. The pound and the Australian dollar use 365, but the Euro and the USD use 360. The calculation should be as follows: • o o
If long: AIR = Relevant Interest Rate + Spread If Short: AIR = – Relevant Interest Rate + Spread
So, if Libor is now at 2.5% for the pound, the spread is 2% and you account is denominated in pounds, then the daily interest rate would be 0.0123288%. Applying this rate to your position, you will be charged £7.32. It is important to note that the next day, you have to recalculate your position value to compute the borrowing cost. If FTSE 100 rises to 6,050, the notional size will be £60,050. Subtracting the required £600 in margin and applying the funding rate, you would pay £7.38. When you go short, the calculation is similar but you are lending funds to your provider. In that case, and using the above example AIR is is -2.5% + 2%, or -0.5%. The minus signal means you are going to receive money instead of paying. You would receive £0.81 per night. Note however, that in some cases, when Libor is very low, you may still have to pay when lending funds. Spread betting companies vary widely in the way they calculate the borrowing cost. Don’t be surprised if most of them charge interest against the entire position value instead
of only against the borrowed part. CMC Markets is a rare example of a provider charging interest just on borrowed funds. For the case of currencies the calculation of AIR needs a little adjustment. If you think about it, when you buy a currency you sell other. It means that you should pay interest on the sold currency and receive in the bought one. The interest applicable is then the result of a differential between two interest rates. Let’s look at another example. You want to buy the AUD/USD currently quoted at 1.1015. The unit risk on this pair is 0.0001. Interest rate for AUD is 4.75% and for USD is 0.25%. You want to stake £10 and the spread is again 2%. First, the notional size for this position is £110,150. If the required margin is £100 per £1 bet, then the total position to fund is £109,150 since you have to keep £1000 in your account. Regarding interest, the AIR is equal to 0.25% – 4.75% + 2%, or -2.5% The dAIR is -0.00685%, meaning you will receive interest instead of paying. If you were to short the pair instead, then the AIR would be equal to – (0.25% – 4.75%) + 2% or 6.5%, meaning we will have to pay 0.0178% per day. Capital Spreads uses the above procedure to calculate interest in Forex markets, but some other providers don’t use Libor rates to calculate the interest rate differential for foreign exchange pairs. Instead they use TomNext procedures based on overnight currency swap rates. IG Index is amongst those using such methodology. Information about swap rates is rarely available at provider’s websites and you will have to contact them directly to obtain such.
The Carrying Cost as Part of Total Funding The funding cost is just one component of the total finance cost. We also have to include the carrying cost. Unlike the borrowing cost that applies every time you are borrowing (or lending) funds, the carrying cost just applies to certain commodities. There is no carrying cost for equities, indices or interest rates. Many providers don’t charge this cost. Don’t be fooled with that! There is no such thing as a free lunch. Remember? If they don’t charge a carrying cost it is because they can include it elsewhere. The three most common alternatives are: 1. It is included in the spread used to calculate the AIR; 2. It is factored into market prices, increasing them 3. It is charged as a certain number of points per night of rolling. For the case in which carrying costs are explicit charged, the calculation is usually done in the following way: Total position value X carrying rate / daily basis
The carrying rate is variable from provider to provider, asset to asset, and with time. It may be 1%, 2%, and even much more. You should ask your provider or look at their market sheets to find the exact figure. CMC Markets provides a breakdown of the full funding cost separating each component and showing the carrying rate, but that is a rare exception.
Final Remarks About Spread Betting Finance Costs The total finance cost is just the sum of the borrowing cost and the carrying cost. As discussed earlier, when the asset is not a commodity, the carrying cost is just nonexistent. It is important to include a reference about what happens at holidays and weekends. Although most spread betting providers are closed on Saturdays and Sundays (open just a few hours), they are charged interest by banks on those days and will pass the cost to you too. The way they do that differs from one to another. Some will charge you interest for three days on Monday night, others charge 3 days on Wednesdays. Holidays will usually be charged two days after. The exact time the rollover is charged is other point of difference between companies and you should investigate your provider policies.
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Published on Sep 7, 2011
Financial spread betting is a simple and straightforward way of trading global markets. Among other advantages, leverage stands out as one o...