Earning or Paying Interest in Your Forex Account

04/10/2009 12:01 am EST

Focus: FOREX

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

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

Each currency pair has an interest payment and charge associated with holding the position long or short. For some pairs, you may receive a payment if you are in a long position, and pay a charge if you are short the pair.

But for other pairs, you may receive an interest payment if you are short, and pay a charge if you are long the pair. Some dealers list the premiums and charges you receive or pay within their trading software, while others list the premiums and charges on their Web sites. These premiums and charges can change on a daily basis, but will typically not change very much.

So how do dealers determine what rates they are going to charge and pay? Dealers derive the interest premiums and charges they use from the difference in the short-term interest rates of the two economies represented by the currencies in the pair you are trading. The short-term interest rate typically used is the overnight LIBOR rate. LIBOR rates are set by the British Banker’s Association (BBA) and are updated on a daily basis.

Let’s take a look at the interest premiums and charges that were once paid and charged on the AUD/USD for example.

Imagine that you were long one contract of the AUD/USD, and the current interest rates, as defined by the overnight LIBOR rates, were 6.67% and 4.28%, respectively. When you are long the AUD/USD, you are actually long the Australian dollar (AUD) and short the US dollar (USD) and will benefit as the AUD rises in value relative to the USD. If you were to net those two interest rates, multiply that amount by the total amount of the base currency, and then divide that number by 360, you 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% × 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 = 0.66 AUD

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. (0.66 AUD x 0.8685 = $0.57)

If you were short the AUD/USD, you would reverse this equation and find the amount you would be charged to be holding the 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 they are also charging you a little more. Dealers take a portion of the interest 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 dealers pay, or charge, interest is through an actual cash payment—which can be approximated with the calculation above—or by resetting your entry price to a new price. The process of resetting your entry price means that if you were long a currency pair and are owed a premium, your entry price is reset to be lower (i.e. better off) than when you first entered the trade. Likewise, if you were short a currency pair and are owed a premium, your entry price will be reset to be slightly higher (i.e. better off) than it was when you first entered the trade.

Conversely, if you were long a currency pair and owe an interest payment, your entry price is reset to be higher (i.e. worse off) than when you first entered the trade. Likewise, if you were short a currency pair and owe an interest payment, your entry price will be reset to be slightly lower (i.e. worse off) than it was when you first entered the trade.

In the AUD/USD example above, if your dealer was resetting your positions rather than making a cash payment, your long entry position would have been reset by .000057—or a little more than half a pip. That means that instead of receiving a cash payment, your net profit in the position went up a little because your entry price was set to a more favorable level.

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

Consider These Tips to Get the Most from 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, your dealer will pay you a higher premium and charge you a lower interest rate on the other side of the 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. Over time, 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 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: The premium payment is one of the factors 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 should consider opening an account with the dealer offering the most consistently attractive premiums for that particular strategy. You may also want to consider opening different accounts with different dealers. 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.

Please watch the video for more.

By John Jagerson, of PFXGlobal.com and LearningMarkets.com.

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