Overnight Surprise: Understanding the Overnight Interest Calculation in Forex
By MURRAY A. RUGGIERO JR.
Article Contributed By Futures Magazine
When you trade the cash forex markets, you incur an interest profit or loss when your trades are held overnight. To develop a forex trading system that carries such trades, you need to make concessions for this interest effect in your analysis.
Two rates are involved when calculating the interest incurred by a trade: a rate for the base currency and a rate for the quote currency. If you have a pair of currencies B/Q with B being the base currency and Q being the quote currency, the following possibilities exist:
· If the trade is long B/Q, interest is charged for borrowing B with the rate determined by B’s borrowing rate. Interest is received from the lending interest for Q determined by Q’s lending rate.
· If our trade is short B/Q, then interest is received from the lending interest for B and charged the borrowing interest for Q.
In both cases, the difference between lending interest and borrowing interest or swap will be incurred. If the lending interest is greater than the borrowing interest, interest is paid to us; otherwise, we have to pay interest. To calculate the difference, both interest values must be converted into the account currency. If the account currency is the same as either the base or the quote currency, no conversion is needed for that currency.
For a particular currency, the borrowing interest rate is always higher than the lending interest rate. Interest applies if a trade is held overnight, which is considered after 5 p.m. Eastern Standard Time. We will look at some examples. In each case, the account currency is U. S. dollars.
Example 1. We enter a trade long one lot of NZD/USD on Monday and maintain the position overnight. The borrowing interest rate for NZD is 7.6%. The interest for one day is calculated at (0.076 * Since the account is maintained in U. S. dollars, this amount needs to be converted to dollars. We find an exchange rate of 0.6808 for the day in question yielding a borrowing interest of $14.18.
The lending rate for USD is 3.75%. To calculate the interest, we need to know the number of USD units equivalent to 100,000 units of NZD, which is given by the price where the trade was opened. For example, 0.6879, making the lending interest calculation (0.0375 * * Subtracting the two interest values of 7.07 – 20.82 = –13.75. Since this value is negative, we will be charged interest of $13.75
Example 2. We enter a trade short one lot of AUD/CAD on Wednesday and maintain this position after 5 p.m . The lending rate for AUD is 5.2%. The lending interest calculation is (0.052 * To convert this value into USD, we need the AUD/USD exchange rate, which is 0.7465, giving us a lending interest in dollars of $10.64.
The borrowing rate for CAD is 3.4%. To determine the number of CAD units equivalent to 100,000 units of AUD, we look to the opening price for the trade at 0.8770. The borrowing interest value is (0.034 * *
For the USD/CAD exchange rate, we find a value of 1.1644, giving a borrowing interest in dollars of $7.02. Note that since the USD is the base currency in USD/CAD, we need to divide the price by the exchange rate or multiplying by the rate of the inverse pair CAD/USD. Subtracting the interest values gives 10.64 – 7.02 = 3.62. Since this value is positive, we will be paid interest. As the trade is open after 5 p.m. on Wednesday, the calculated interest must by multiplied by 3, giving an interest payment of 3 *
Both examples show that it is necessary to know the price where the trade was opened to calculate the interest contributed by the quote currency, as this determines the number of units of the quote currency sold or bought when the trade was opened.
Example 2 shows that when the base currency and the quote currency are both different from the account currency, access to price quotes of additional pairs is necessary. To convert the lending or borrowing interest rate, we need a quote for the pair at the time of the rollover.
The bottom line is that you need to include the effects of interest rates in your historical testing. This effect can be sizable. For example, trading forex on an end-of-day basis with a 20-day channel breakout, the interest rate effect could account for a 25% adjustment in the profit or loss of a given trade.
Murray A. Ruggiero Jr. can be reached at ruggieroassoc@aol.com.