One market convention unique to
currencies is rollovers. A rollover is a
transaction where an open position from one value date (settlement date) is
rolled over into the next value date. Rollovers represent the intersection
of interest rate markets and forex markets.
Currency Is money, after all
Rollover rates are based on the
difference in interest rates of the two currencies in the pair you’re trading.
That’s because what you‘re actually trading is good old-fashioned cash. That’s
right: Currency is cold, hard cash with a fancy name. When you’re long a
currency (cash), it’s like having a deposit in the bank. If you’re short a
currency (cash), it’s like having borrowed a loan. Just as you would expect to
earn interest on a bank deposit or pay interest on a loan, you should expect an
interest gain/expense for holding a currency position over the change in value.
The catch in currency trading is
that if you carry over an open position from one value date to the next, you
have two bank accounts involved. Think of it as one account with a positive
balance (the currency you’re long) and one with a negative balance (the
currency you’re short). But because your accounts are in two different
currencies, the two interest rates of the different countries will apply.
The difference between the
interest rates in the two countries is called the interest-rate differential. The larger the interest-rate
differential, the larger the impact from rollovers. The narrower the
interest-rate differential, the smaller the effect from rollovers. You can find
relevant interest-rate levels of the major currencies from any number of
financial-market Web sites, but marketwatch.com and fxstreet.com have especially-good resources. Look
for the base or benchmark lending rates in each country.
So how do interest rates get
turned into currency rates? After all, interest in rates are in percent and
currency rates are, well, not in percent. The answer is that deposit rates yield actual cash
returns, which are netted, producing a net cash return. That net cash return is
then divided by the position size, which gives you the currency pips; which is
rollover rate.
The following calculation
illustrates how this works. I’ve simplified matters by using just one interest
rate for each currency. In the real world, each currency would have a slightly
different interest rate depending on whether you‘re borrowing or lending
(depositing).
Position: Long EUR/USD 100,000 at 1.3000
(long EUR/ short USD 130,000)
EUR interest
rate: 3.50 percent per annum → 1 day = 0.035 x (1 ÷ 365) =
0.009589
percent
Euro deposit
earns: 100.000 x 0.00009589 = EUR +9.59
USD interest rate:
5.25 percent per annum →1 day = 0.0525 x (1 ÷ 365) =
0.01438
percent
USD loan
costs: 130,000 x 0.0001438 = USD -18.70
Because
EUR/USD pips are denominated in USD, convert the EUR to USD: EUR 9.59 x 1.3000
= USD 12.47
Net the USD
amounts 12.47-18.70 = USD -6.23 ÷ 100,000 = 0.0000623
On a long EUR
100,000 position, the rollover costs 0.0000623 or -0.623 pips.
