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Forex Essentials Course: 21 lessons to get started in Forex

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6. Earning Interest in the Forex

Wed, Oct 22 2008, 08:50 GMT
by PFX Team

LearningMarkets.com

Forex trading accounts have interest considerations

"Interest," "roll-over," "tomorrow-next," and "cost of carry" are all terms used by dealers to describe the premium paid or charged on each forex pair.

Each pair has an interest payment and charge associated with holding the position long or short. On some pairs, a payment may be made if you are in a long position, and a charge is made if you are short the pair.

But on other pairs, an interest payment may be made if you are short and a charge occurs if you are long. Your dealer may list those premiums and charges within their trading software, or you may have to look on their website for more information. The premium can change on a daily basis but will typically not change very much.

This interest premium is derived from the difference in short term interest rates between the two economies represented by the currencies in the pair you are trading. The short term interest rate used is the overnight LIBOR rates. These are typically set by the British Banker’s Association and are changed on a daily basis.

For example: the AUD/USD

Imagine that you are long one contract of the AUD/USD and the current interest rates as defined by the overnight LIBOR rate is 6.67% and 4.28% respectively. When you are long the AUD/USD you are actually long the AUD and will benefit as it rises in value relative to the amount of USD that you are short. If you were to net those two interest rates then multiply that amount by the total amount of the base currency and then divide by 360 you would arrive at a close approximation of the interest premium.

Step 1: Determine the difference between the overnight LIBOR interest rates of the two currencies involved in the pair. (AUD 6.67%) – (USD 4.28%) = 2.39%

Step 2: Multiply the difference between the two interest rates by the amount of the base currency you have tied up in your trade 2.39% X 10,000 (one mini-lot) = $239

Step 3: Divide the amount in step 2 by 360 days to determine the interest payment amount in the base currency 239/360 = .66AUD

Step 4: If the base currency is different than the currency you hold your account in, use the current exchange rate between the base currency and your account currency to convert the amount into your account currency (0.66AUD x 0.8685 = $0.57)

If you were short the AUD/USD you would reverse this equation and find the amount you should be charged to be holding that position.

That sounds pretty good - and it is. However, because you are working with a dealer, you will find that they are paying you a little less than you may have expected and charging you a little more. They are taking a portion of this premium as part of their service charges to you - the trader. The actual premium paid on any single position will vary a lot from dealer to dealer and with different account types.

Interest premiums are paid in different ways, depending on the dealer

The most common ways that you are paid or charged this interest in through an actual payment, which can be approximated with the calculation above or by resetting your position in a more or less favorable price. This process of resetting your position means that if you were long and are owed a premium your entry price is reset to be lower than when you first entered. Likewise, if you are short and owed a premium your entry price will be reset to be slightly higher than it was originally.

In the example above, if your dealer was resetting your positions rather than making a premium your long entry position would have been reset by .000057 or a little more than half a pip. That means that your net profit in the position went up a little because of a more favorable entry.

While it is common for these payments to be made around 10:00pm - 12:00am GMT, they can vary by dealer and in some cases; dealers may spread the premium into a continuous payment based on how long you held the position. Like many things it is also important to understand how dealers compete based on these rates and some of the pitfalls you can avoid related to this premium.

Consider these tips to get the most out of your dealer

Tip #1 – Most dealers will pay more if you are willing to carry a lower maximum leverage rate in your account. That means that if you are willing to have a maximum leverage rate of 50:1 instead of 200:1 then they will pay you more in positive premium and charge you less if you are on the other side of that transaction. Since a 50:1 leverage rate is still extraordinarily high and will probably never be maxed out in your own account anyway this is a good deal for you. The difference in interest paid and interest charged can be very large.

Tip #2 – On Wednesdays the interest premium is triple the normal amount. That may make a difference in your trade timing if you are considering a currency pair with a very high interest rate payment/charge. This is done because the market is essentially closed on Saturday and Sunday so the value date is extended to Monday.

Tip #3 – This premium is one of the factors that dealers will use to compete for your business. If you are trading a strategy, such as the carry trade, which relies on high interest payments you may consider opening an account with the dealer offering the most consistently attractive premiums specifically for that portion of your account set aside for that strategy. Having an account with more than one dealer can be a very good thing and can help you take advantage of each dealer’s strengths.

Tip #4 – Some dealers will give you a better rate if you CALL THEM AND ASK FOR IT. If you are working with a dealer you like but the premium seems low, call and find out what it takes to get the higher rate. You may be surprised by what they are willing to do for you. Remember who works for whom.

Forex Essentials Course - 21 lessons:

Published on  Thu, Nov 20 2008, 09:27 GMT