In the foreign exchange markets, the word "swap" can have two different meanings. For example, a foreign exchange swap or interest rate swap is a type of transaction involving an agreed upon exchange of two different currencies - each at a particular interest rate that accrues over time. A swap charge refers to an interest rate differential between two currencies and is applied to spot Forex trades that are held overnight.
This article will focus on later of these two definitions, as it applies to the cost of carry or interest rate charges, known as premiums, that can be either negative (a cost) or positive (a return) when spot Forex traders hold positions overnight (generally past 5 pm EST). The swap charge will vary with broker/bank, and depending on whether traders are buying the base currency in a pair or selling it.
Relationship of Swap charges to the Carry Trade
This article will also discuss the carry trade as described below. We will focus on answering the following: how does the carry trade relate to the swap in Forex trading?
The swap rate for buying can be either negative or positive, just like the swap rate or interest rate applied to selling a specific pair can be a positive net credit or negative net-debit, charged against a trader's account. Therefore, market participants need to be aware of not only what the swap rates are for a particular currency but also whether it is positive/negative when buying or selling.
Overnight Financing Charges that can cause a net credit or net debit in a Forex account. Having a thorough knowledge of how a Forex overnight rollover rate is calculated an important step in understanding how the Forex markets operate.
An excellent way to understand how financing charges can affect trading results is to experiment with a demo account, and can help to understand better both how to plan in advance, such as using a trade calculator as seen below, and then comparing overnight the rates applied and subsequently reflected on the individual customer statement.
Why are swap rates applied?
The interest rates that banks apply to deposits and loans varies from country-to-country depending on the interest rate environment of that particular country’s monetary policy.
When there a significant interest rate differences between countries, funds can be borrowed from one country at a lower rate and invested on deposit in a country whose banks will pay a higher rate. This type of trade is known as the carry trade and is a trading strategy that aims to capture this difference in the interest rate that creates an arbitrage opportunity (with the interest rate - not the forex rate).
A simple way to understand the essence of a carry-trade strategy is that it combines borrowing in a low-interest rate currency used to fund a deposit in a higher-yielding target currency, whereas the borrowed funds are initially exchanged for the target currency in the spot FX market and deposited in a higher-yielding account. At the conclusion of the trade, the collected funds are withdrawn and exchanged back to the funding currency using spot fx exchanges rates. The result of the trade or return on investment (ROI) depends on both the difference between the borrowing and deposit rates yet often more importantly on the exchange rate movements during the time of the trade.
Since the global financial crisis that spiraled since 2007, interest rates have been continually cut in most major economies and thus created what is called a low-interest rate environment. However, according to the Bank for International Settlements (BIS), the re-emergence of widening interest rate yields across the globe could cause the carry trade to regain appeal. Nonetheless, because of the differences in interest rates, swap rates are applied to carry Forex trades over time. For this reason, some traders purposefully exit the market before the end of the trading day, a process known as day-trading.
What does the carry trade have to do with swap and financing charges?
This process known as the carry trade could enable an investor to capture the interest rate difference that will be the cost to borrow minus the return on interest from the borrowed money deposited.
For example, an investor that borrowed 10 million Australian Dollars’ worth of Japanese Yen from a bank in Japan can take those Yen and convert into AUD then deposit the 10 million AUD into a local bank in Australia, which could pay a higher yield than the cost to borrow. So if the Japanese bank offered a rate of 2% and the Australian bank paid 4% on the proceeds of the loan deposited, the net profit would be a 2% return (4% yield minus 2% cost to borrow=2% return).
Thus the cost of carrying forex trades over time, is designed to take into consideration this difference in interest rates for respective currencies in a pair, and may also apply a premium depending on some other factors such as the available leverage selected and the market sentiment.
Low-Interest Rate Environment, and re-emergence of widening interest rate yields
Before that period, the carry trade was more attractive, and investors seeking the highest return in JPY priced currency pairs would buy the base currency and thus sell JPY, creating the synthetic interest rate arbitrage as described above.
However, considerable risk existed in the strategy as successive periods of Yen depreciation were followed by short periods of Yen strength, which caused investors to get crushed whenever the Yen rate dropped swiftly.
While transactions like these occur for commercial reasons and for those who have a need for the capital, in foreign exchange speculators can trade a particular currency pair to create synthetically a situation similar to the carry trade example above.
One crucial point in both actual and synthetically made carry trade positions is the risk to exchange rate fluctuations. That is, regardless of the interest rate that can be made, after costs, there is exchange rate risk and can be an even more important aspect of the trade than the cost of carry or swap rate alone.