Forex Carry Trade: Free Interest on Leveraged Money

by : Jason Fielder

Interest rates can have a major effect on how certain currency pairs are traded. For some traders looking at a long term trade, the practice of collecting rollover comes into effect.

Rollover is when interest is figured out between the currency pairs each day and paid to you or from you. Different currencies have different interest rates, and collecting the spread between the currencies interest rates is where the Forex carry trade comes in.

Carry trades are trades that are done with specific currency pairs with the thought of earning interest in mind. Whenever two currencies are being traded, a fee occurs that has to be paid. Basically that fee exists because there is a difference in interest rates between the two currencies, and that difference has to be addressed in order to balance the difference out in the Forex transaction.

If the trader is buying a currency with the higher interest rate, then they can earn credit, which sometimes can be as much as 20% of the total profit of a transaction. This is a carry trade: a longer term trade going at least one full day but typically longer, which results in interest being accrued.

Here's how the interest due is figured. Let's use the U.S. Dollar-Japanese Yen (USD/JPY) pair as an example. Suppose the interest rate in the United States is 5.5%, while the interest rate in Japan is only .5%. Since the currency pair is USD/JPY, subtract 5.5 - .5 = 5%. Since there is 5% left over, that amount needs to be credited to the trader that is long the USD/JPY pair. That's the additional bonus that comes with a successful carry trade.

The basic reasoning behind this is that when you are trading this currency pair, you are "borrowing" the Yen at .5% to purchase US Dollars, which are paying 5.5%, so 5% becomes the left over difference. The interest is figured daily, and while holding this position, you will earn interest from the daily rollover.

Certain Forex currency pairs have a tendency to catch a long term upswing when interest rates change, in part because a large number of traders will specifically look for the opportunity to take advantage of these pairs and the interest positive rates that they offer. This can be a very beneficial long term trade strategy.

If you're considering a long term position with a currency pair, the interest rate may be a major consideration since up to a quarter of your profits from a long term Forex carry trade may come from the positive interest being credited to your account. Not a bad way to go, making profit from the interest of leveraged money.