The Interest Rate (Rollover)

Forex traders make money either buying low then selling high, or selling high then buying low. Profits and losses are determined by the opening and closing prices and by the pip value as you have studied in the previous section. However, profits and losses will also be affected by the different interest rates of the currency pair - by when the trades actually settle and how long the position is held.

Rest assured that the importance of this topic can eventually represent an advantage to your trading. Let's proceed by recalling the concept of exchanging two currencies from the beginning of the chapter.

Every currency trade involves selling one currency and buying another. This exchange is the same as borrowing one currency to buy another. Since every pair consists of two currencies representing two economies with two different interest rates, most often it derives in an interest rate differential in the pair. This differential will, in turn, result in a net earning or payment of interest.

The interest that is earned or paid is usually the target interest rate set by the central bank of the country that issues the currency. More precisely, the interest rates used are the short term overnight LIBOR and LIBID rates, because most of the spot trades are short term. These are typically set by the British Banker’s Association and are changed on a daily basis.

Countries don’t change interest rates often, therefore the interest earned or paid can change on a daily basis but will typically not change very much. So a trader does not have to worry about timing the market too closely on this subject.

The interest is debited (paid) on the currency that is borrowed, and credited (earned) on the one that is bought, so that each pair has an interest payment and an interest charge associated with holding the position.

This means that if a trader is buying a currency with a higher interest rate than the one he/she is borrowing, the net differential will be positive and the trader will earn funds as a result.

Depending which member currency within the pair has the higher interest rate, on some pairs a payment may be made if you are buying it, and a charge may be made if you are selling it. But on other pairs, an interest payment may be made by selling it and a charge occurs when buying.

Most Forex broker-dealers automatically roll over the positions from one day to the other until the trader closes the position - a process called, naturally enough, a "rollover". Practically all trading platforms adjust the rollover to your account automatically, so you do not have to calculate it. This premium can also be called using the terms "swap", "tomorrow-next," or "cost of carry".

The rollover is necessary to avoid the actual delivery of the currency. As spot Forex is predominantly speculative, most of the time traders never request the actual delivery of the currencies they trade. Besides, delivering the currency is almost impossible with the leverage effect, because there is usually not enough capital to cover the transaction.

Since the amount of the rollover is determined by the interest rate differential, the greatest interest can be earned by buying the currency that pays the highest interest and selling the currency that charges the lowest interest.