Complex terminology can terrify the best of us, particularly for newer traders.
In the foreign exchange market, or Forex market, the swap is the interest paid at the time of the rollover. While this may sound a mouthful, it’s relatively straightforward. It is the process of extending the settlement date of an active trade to the next day (the next trading day), referred to as Tomorrow Next, or Tom-Next. Think of this as an extension granted to open positions to avoid taking delivery of the underlying asset.
At its core, carry trading strategies attempt to exploit positive swap environments. The swap rate, however, can also affect those trading sizes.
Central banks provide financial and banking services to their government and commercial banking system of their respective country.
Central banks, such as the US Federal Reserve (The Fed), the Bank of Japan (BoJ), the Reserve Bank of Australia (RBA), and the Bank of England (BoE) set base interest rates. An example, while not accurate at the time of writing, is the RBA might have a 6% interest rate, while the BoJ might have an interest rate set as low as 0.25%.
Swaps are a derivative of these two interest rate differentials. You’re effectively trading the interest rates between central banks.
Traders should acknowledge a spot FX trade is similar to a futures contract with a 2-day settlement period (business days). What this means is if rollover did not occur, traders are then required to buy/sell their existing positions every two days to avoid facing the delivery of the underlying financial instrument, in this case, currency. Most brokers process rollovers at 5 pm Eastern Standard Time – the close of US trade. Triple interest is also paid on Wednesday, covering the weekend as brokerages and banks close. Tom-next trades are in place due to the majority of traders using the currency market for speculation rather than a place to take delivery of physical currency. Therefore, it’s essential positions are rolled on a daily basis.
Typically, credit may be earned as long as the long currency’s interest rate is higher than that of the short currency. Likewise, the account may be debited if the interest rate of the short currency is higher than that of long currency. If you’re an intraday trader (short term), or scalper, this isn’t a concern as trades are liquidated before the close of trade at 5 pm EST.
In the case of the RBA and BoJ’s hypothetical interest rates highlighted above, should you purchase (a long position) the Australian dollar/Japanese yen exchange rate (AUD/JPY spot rate) during this time and held overnight, that currency pair offers a 5.75% interest rate differential. As such, a long trade in AUD/JPY that’s held for a year earns 5.75%. This is a positive carry.
If you sell AUD/JPY, on the other hand, you’re short the AUD and long JPY. In this case, you’ll pay 5.75%, representing a negative carry. Remember, in currency trading, exchange rates trade in pairs. You buy one and sell the other, and vice versa.
Generally, though, swap represents a small value for most. However, it can become significant if holding long-term positions. Holding a trade open to earn the swap, as briefly underlined at the beginning of this piece, is referred to as carry trading.
A carry trade involves borrowing currencies at low-interest rates while investing in currencies boasting high-interest rates (high yielding currencies) This what was referred to as a positive carry above. In FX, daily credits and debits from the swap interest rate differential are received in trading accounts. Well documented carry trade examples are that of selling the Japanese yen and buying the Australian dollar or New Zealand dollar.
Carry trading, however, is not without risk. The interest rate differential between the two traded currencies is not the only factor; the currency pair’s price action, the price movement’s value, is important as well and could result in losses despite a positive carry. Therefore, it is crucial traders adopt robust risk-management principles, as in any other type of trading strategy.
Carry trading is typically favoured during times of economic prosperity – market conditions exhibiting a risk-on trading environment. By trading in the direction of positive interest, traders receive both trading and interest earnings, which can be magnified with the use of leverage.
Calculating the Swap Rate
How to calculate the swap rate is a common question as swaps are illustrated in MT4 points; traders sometimes have difficulties in understanding how this translates to monetary value, your account value. However, there’s a simple solution to this.
In MetaTrader 4, or MT4 (see figure 1.A), traders can view the swap rates in the contract specification tab. Open your MT4 trading platform and select the Market Watch. Then right-click the pair traded, in this case, it’s the GBP/CHF, and select specification. Following this, scroll down and locate Swap Long and Swap Short values.
For the Swap Long rate, for GBP/CHF, its 3.02 MT4 points; this is what we’re credited into our account if we hold a GBP/CHF position overnight for a 1 standard lot size. For the Swap Short rate, it’s -11.04. In this example, let’s assume the account balance is denominated in euros.
To calculate the swap rate in monetary value for euros, we take the swap points from MT4 and divide this amount by the EUR/CHF exchange rate which is, as of writing, 1.05498 (3.02/1.05498) which equals 2.86 euros. In this case, you would be paid, or credited, the value of 2.86 euros into your account. For short positions, the Swap Short Rate is -11.04. Here you divide -11.04 by 1.05498, equating to 10.46 euros debited from your account, based on 1 standard lot.
The same formula applies to all currencies (Euro [EUR], New Zealand dollar [NZD], Swiss franc [CHF], US dollar [USD] and so on).
To make life a little easier, FP Markets offers an all in one FX calculator, allowing you to compute several important parameters, such as pip value, contract size, swap rate value, margin and potential profit. This lets you focus on the trade, knowing the other important metrics are taken care of.
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