The currency market is designed to facilitate the trade of money between
two parties interested in actually delivering the currency being traded. The
contracts traded on the spot market are designed to settle within two business
days. Since most currency trades are speculative and traders do not
want an armored car full of money to show up at their house, currency
dealers automatically expire open positions and roll their settlement date
forward two more business days. This process, known as the rollover,
takes place at the end of each trading day, around 5:00 P.M. Eastern Time.
Avoiding settlement is just one benefit; the rollover process also settles
interest payments to your account, depending on your open positions.
Earning interest for simply holding a position open is a benefit of trading
money. Each currency pair has an associated cost-of-carry premium,
which is either positive to your account or negative, depending on whether
you are long or short. The premium is determined roughly from the central
bank rates in the currency’s home country. For example, if you are long
AUD/USD while the central bank rate in Australia is 3.5 percent and the
central bank rate in the United States is 0.25 percent, you should expect
to be paid some of the difference between these two interest rates as calculated
on the total size of your open trade. If you were short AUD/USD
in this example, you should expect the difference to be debited to your
account. There are some variables that affect the actual interest payment
paid or charged to your account.
The actual interest rate used to calculate carry premiums is the London
Interbank Offered Rate (LIBOR). This short-term interest rate is a
benchmark rate maintained on 10 currencies by the British Bankers Association
(BBA). The rates are determined through a survey process conducted
by the BBA of 8 to 16 contributing banks per currency. The survey
determines the lowest average rate at which banks are willing to borrow
funds overnight and performs a calculation on that data to determine the
LIBOR. The difference in LIBOR rates between two currencies determines
the base cost of carry for your open position in the forex market. If you are
interested in the specific details of how LIBOR is calculated, I recommend
you visit the LIBOR web site at www.bbalibor.com.
Let’s look at an example to understand how the carry premium is calculated
using the LIBOR during the nightly rollover.
Assume that you have bought 100,000 units of GBP/USD. In this trade
you are buying the British pound and selling the U.S. dollar. If the LIBOR
for GBP is 2.4775 percent and the LIBOR for USD is 2.07 percent, the difference
between the two currencies is 0.4075 percent. The difference is multiplied
by your total position size, in this case, 100,000 × 0.004075, which
equals 407.5 units of currency. LIBOR rates are annual yields; therefore,
407.5 represents the annual yield. Divide 407.5 by 360 days to determine the
nightly interest premium, which is 1.13 units of currency. If the base currency
in your trade is different than the currency your account is funded in,
you must also multiply the interest payment by the currency exchange rate
to convert the interest payment to your account’s currency. The current
GBP/USD exchange rate is $1.5928. The final calculation to convert 1.13 to
dollars is 1.13 × 1.5928, which equals a final nightly premium of 1.79 units
of currency.
by broker because many brokers derive income from the overnight swap
payments before passing those rates on to you. Brokers routinely publish
their swap rates for each currency and typically post them on their web
sites. Traders should be aware of these rates and understand that holding
a position against the carry could cause them to pay significant interest
if they plan to hold the position open for a long period of time. Finally,
traders should be aware that on Wednesdays the interest premium is triple
the normal amount. This accounts for positions that are set to be settled
on Saturdays or Sundays, when the market is essentially closed, by setting
their valuation date to Mondays.