Interest and Carry Trade in Forex (learn forex online)

Rollover and Carry

Very "interesting"...

As individuals borrowing money, or keeping money in a bank account, we are accustomed to paying interest to the bank on borrowed money, and earning it on money on deposit.

The same is true of the forex market. Interest is paid and earned on currencies traded.

Remember, when a trader enters a forex trade, one currency is purchased while the other is sold. One way to think of this trade (and a fairly accurate one) is to consider the purchased currency to be owned and the sold currency to be borrowed for the duration of the trade. Just as is true with interest at banks, the 'borrowed' (or sold) currency in the trade incurs interest charges, while the owned (or bought) currency earns interest.

In forex markets, the interest owning or paid is calculated only on positions held overnight (with the close of day usually considered to be 5 pm North America Eastern time). If a trade is entered during a day, and exited before the end of the day, it neither earns interest nor incurs interest charges.

What actually happens, at least in theory if not in practice, is that all forex currency trades are closed at night, and re-opened the next day. This event occurs automatically for all trades that remain open at the close of trading. The event and practice is called 'rollover', while the net interest owned or paid is called "carry" (or sometimes "roll").

The interest rate paid on the purchased currency, or charged on the sold currency is based on the prevailing interest rate associated with each currency. For example, if a trader buys USD/JPY, the trade earns currency at the rate paid in the U.S.A., and pays currency at the prevailing borrowing interest rates charged in Japan. Those rates can differ substantially.

For trades held open for longer than the present day, the carry interest owned or paid can be an important consideration, and adds a dimension to forex trading for any trades held overnight. Some traders also look to carry interest for opportunities to profit.

Carry trade can also can offer opportunities for profit.

Carry Trade

Carry interest should be taken into consideration whenever forex traders hold currency pairs overnight. Some even consider carry to be an important ingredient of trading strategy.

Consider the following, rather unrealistic and exaggerated example.
A trader purchases a full size AUD/JPY at the start of the year. The trade at that point consists of an equal value of Australian Dollar owned, and Japanese Yen owed. Assume that the Australian interest rates are about 5.5%, and the interest rate for the Japanese Yen is about 0.5%. The trader keeps the trade open for a year, and (amazingly -for the sake of example) when the trade is closed Dec 31, the value of the AUD/JPY is unchanged. There is neither profit nor loss on the trade, that is, until the carry interest is considered.

For the year, the trader earned interest on the Australian Dollar, and paid interest on the Japanese Yen added to, and removed from the trader's trading account nightly (due to rollover). At the end of the year, the Trader earned 5.5% on the Australian Dollars owned, and had to pay just 0.5% on the Japanese Yen owed. Therefore, the net interest earned on the trade for the year was 5.0%, and the trader would have earned $5000 Australian Dollars in interest. If leverage on the account is 100:1, the amount of margin required for the trade would be $1000 Australian Dollars - and the return on that investment would be $5000/$1000, or 500%!

If only life was that easy!

Unfortunately, the reality is that the above example is exaggerated. In reality - both at the bank and with your forex broker-there is a spread in interest rates. You cannot normally borrow money and pay interest at the same interest rate that is paid when you invest funds. For that reason, the amount of carry paid is less than might otherwise be expected, and the amount charged might be higher than expected.

Other complications relate to the risk that the currency pair value will change. A relatively small unfavorable change in the currency rate can reduce or eliminate carry interest earnings.

Therefore, a trader must be very cautious when looking to carry as a reliable source of earnings in forex trading.