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Forex Swap - The Hidden Cost of Trading Forex

Dave

New member
Most new forex traders may be unaware of what forex swap is and how they are unknowingly ending up paying money for it. You enter forex trading with the hope of earning some money, but there are often some hidden costs when trading forex that no one will tell you about unless you do your own research. Swap is one such “fee” that can significantly affect your trading account.

When trading forex, what is a forex swap?

Swap refers to a simultaneous exchange of two different currencies between two parties. It is usually done to procure loans in a different foreign currency at better interest rates. One party borrows a particular currency from another party and simultaneously lends another currency to that party.

Both parties take a loan in their respective currencies and agree to swap the principal amounts and interests on the loans. So, the two parties continue to pay the interest on the currency that they have received through the swap. Once the agreed term period of the swap is over, the principal amounts are again exchanged at a previously agreed rate. This rate is also called the spot rate. The spot rate is the exchange rate or current market value of both currencies on the date of settlement. For forex spot transactions, the settlement date is usually two business days from the trade date.

The currency interest rates and interest rates in forex decide whether you will be receiving money from the swap or paying for it.

On what factors in trading forex does the swap rate depend?

Whether the forex swap works in your favor or against you will depend on certain critical factors.

Currency interest rate

All currencies are managed by the central bank of their respective countries. The central bank decides a particular currency’s interest rate. This interest rate is the amount of money anyone can make when they lend out that particular currency. So, if you are borrowing a currency from another party, you are supposed to repay the amount with interest.

The same goes for the other party since in a forex swap, currency is being exchanged between both parties. In such a case, whichever currency has a higher interest rate should bring more returns.

Interest rates in forex

Then there is the interest rate associated with the forex market as well. This is the amount that your broker will charge if you keep a trade open overnight for as many days as you hold this position. If you close the trade before midnight, the broker does not charge you anything for the swap, but if you leave it open for the next day, a rollover fee will be charged for holding it, depending on the forex interest rate.

How is the rollover fee calculated?

You need to understand why this fee is charged by your broker and how it is calculated against a currency swap, so you can make better decisions. Let us consider an example where you’re swapping the US dollar against the Euro. It is important to remember that when currency exchange is taking place, your broker cannot deliver the currency physically to your account, but the amount you are paying is debited from your trading account.

So, let us say you are buying 10,000 Euros from your broker against a sum of 11,000 USD borrowed from your broker. The broker does not deliver the 10,000 Euros to your bank account, but the amount in USD is deducted from your account. This technically means that the broker is borrowing 10,000 Euros from you. This is a swap.

Now the interest rate comes into the picture. The central banks decide the interest rates for overnight lending for the respective currencies. In this example, the interest you pay for borrowing the USD from your broker is set by the Federal Reserve System. While the interest your broker pays to you for the Euros they have borrowed will be set by the European Central Bank. The difference between these two rates will be the swap rate.

Now, if the Federal interest rate is set at 0.75% and the ECB interest rate is 0%, annually, here’s how it works. You need to pay your broker 0.75% annually or 0.00208% daily on the borrowed USD amount, while your broker needs to pay 0% for the Euros they borrowed.

So, for every day that the position is open, your broker will charge you the difference amount between 0 Euros and 0.23 USD. This is the negative swap or interest rate you pay to your broker for holding the position.

If it had been the other way round, and the ECB interest rate had been higher than the Fed interest rate, you would be earning the difference amount per day.

How to gain from a swap in trading forex?

You need to make careful, strategic moves in forex trading if you want to be gaining from swaps instead of paying up. For example, swapping when you feel that the currency pair with a big positive difference in interest rates is going to be stable for a long period, you can earn huge amounts in interest from the broker.

Keep track of the central bank interest rates and latest forecasts so that you can make well-informed decisions regarding swap in trading forex. Also, closely follow the swap calculation methods and rate offered by your broker to avoid additional forex trading costs.
 
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