Where do carry rates come from? | Forex Factory

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Where do carry rates come from?

  • #1
  • First Post: Jun 3, 2014 12:54am Jun 3, 2014 12:54am
I am finding it hard to explain why one is entitled to the overnight carry rate with FX trades. I found I couldn't easily find it on the internet either so I came here.

So what entitles you to the carry rate? Its not like your money is in a bond. I get that its based off of the fed funds rate, but why do you even receive that. That is the price for banks to loan to each other and what prompts the bank to be so accommodating to you and give you this rate? It's not like any of your money sitting in the bank gets a rate even close to that.

I just can't see where the rate is actually coming from and why it is there in the first place. Can someone please help me out here?
  • #2
  • Jun 3, 2014 2:32am Jun 3, 2014 2:32am
Try coastal (day) trading ds - no need to worry about o'night rates then!!

Anyway, soon enough a scholarly poster will educate you........
Keep It Simple Stupid
  • #3
  • Jun 3, 2014 2:48am Jun 3, 2014 2:48am
Try reading this: http://www.investopedia.com/terms/c/...carrytrade.asp

Think: Differential currency interest rates
  • #4
  • Jun 3, 2014 3:47am Jun 3, 2014 3:47am
Quoting Danny Maina
Try reading this: http://www.investopedia.com/terms/c/...carrytrade.asp Think: Differential currency interest rates
Thanks for the reply, I get the basic mechanics of the carry trade and I have no issue with calculating what it is. But what I am asking is what mechanism within the realm of interest rates lets me pocket the money. After all I am not buying a bond with the money, I am just buying some currency.

Banks loan money to each other at the Fed funds rate, but what prompts them to give me a cut of that action? I mean a regular checking account deposit would get almost nothing from this, so why do I get it? I used to be comfortable with how all this works, but I have somehow forgotten it now.

Any input would be great.
  • #5
  • Edited 7:31am Jun 3, 2014 7:14am | Edited 7:31am
Good question, because I am not myself how a person receives interest from just switching from one currency to another.

I was under impression though that the most important differentials was the bond yields, stock market PE's etc.
  • #6
  • Jun 3, 2014 7:18am Jun 3, 2014 7:18am
this might help you... its with regard to forward rates being discounted to prevent arbitrage...

http://www.dukascopy.com/fxcomm/fx-a...n=read&id=1862
  • #7
  • Jun 3, 2014 7:31am Jun 3, 2014 7:31am
Quoting deltaskelta
{quote} Thanks for the reply, I get the basic mechanics of the carry trade and I have no issue with calculating what it is. But what I am asking is what mechanism within the realm of interest rates lets me pocket the money. After all I am not buying a bond with the money, I am just buying some currency. Banks loan money to each other at the Fed funds rate, but what prompts them to give me a cut of that action? I mean a regular checking account deposit would get almost nothing from this, so why do I get it? I used to be comfortable with how all this...

Because it's actual money you're trading. You're using your funds at the broker to leverage it into being able to buy a currency pair. When you do so, suppose you go long EURUSD, you are long EUR 73,500, and short $100,000 USD. Since you're then holding 73500 euros, you receive the interest that is paid on those Euros, whilst you are short the $100,000 dollars and so you owe the interest payable on that. The banks that facilitate this typically take a small cut for rollover, but aside from this the interest is yours. So if interest on Euros was really high (it isn't!) and interest on USD was really low, you'd be receiving money.
  • #8
  • Jun 3, 2014 7:47am Jun 3, 2014 7:47am
Quoting JeremyWS
this might help you... its with regard to forward rates being discounted to prevent arbitrage... http://www.dukascopy.com/fxcomm/fx-a...n=read&id=1862
The forward rates are what the market thinks the interest rate differential might be in say 1 years time? - so in this case you are arbitraging against futures rates?

Does this take into account differential interest rates right now?


Quoting SupraSense
{quote} Because it's actual money you're trading. You're using your funds at the broker to leverage it into being able to buy a currency pair. When you do so, suppose you go long EURUSD, you are long EUR 73,500, and short $100,000 USD. Since you're then holding 73500 euros, you receive the interest that is paid on those Euros, whilst you are short the $100,000 dollars and so you owe the interest payable on that. The banks that facilitate this typically take a small cut for rollover, but aside from this the interest is yours. So if interest on Euros was really high (it isn't!) and interest on USD was really low, you'd be receiving money.
I think I understand this, still don't get the forward connection posted above by Jeremy.
  • #9
  • Jun 3, 2014 8:15am Jun 3, 2014 8:15am
Quoting MCRotter
{quote} The forward rates are what the market thinks the interest rate differential might be in say 1 years time? - so in this case you are arbitraging against futures rates? Does this take into account differential interest rates right now? {quote} I think I understand this, still don't get the forward connection posted above by Jeremy.
The forward rates are what the market thinks the interest rate differential might be in say 1 years time? - no its not.

Does this take into account differential interest rates right now? yes

You can trade different tenors of forwards to recieve different net carry. If you are in spot trade, you roll with o/n swap rate (each day this changes but not much) if you hold for a month, you recieve 22*o/n swaps.

Where as if you traded a 1 month forward contract as opposed to a a spot trade, you have an inherent interest rate trade, which will make profit/loss if interest rates move a lot in that period... (but obvsioulsy they dont)

furthermore, a 1Y swap is not what the market expects in 1Y, nor is it 365*o/n in theory, but in practice it is because of imperfections.

You can always DM me with any specific questions.
  • #10
  • Edited 11:10am Jun 3, 2014 10:44am | Edited 11:10am
As you've found out... this isn't a straight forward question to answer.

The carry/swap/roll-over is basically the overnight swap rate(swaps are derivative contracts) for the equivalent synthetic FX swap position.. due to your broker automatically deferring the value(delivery) date on your spot position. To understand how FX swaps work and how they are priced (to determine the swap cost/credit when you buy/sell) have a read here http://www.forextraders.com/forex-st...rex-swaps.html

The swap differential is affected by the central banks base(repo) rate of the currencies involved BUT this isn't as straight forward as it appears, swap rates are NOT central bank interest rates... instead they are derived using these rates and other factors.

Don't worry you're not alone...even after comprehending how this works many times in the past, I still have to refresh my memory when the subject arises.
  • #11
  • Edited 12:43pm Jun 4, 2014 12:17pm | Edited 12:43pm
Quoting JeremyWS
this might help you... its with regard to forward rates being discounted to prevent arbitrage... http://www.dukascopy.com/fxcomm/fx-a...n=read&id=1862
Thanks for the article, but I don't think this really answers what is puzzling me. If im not mistaken, this is just explaining the contango in the currency forward or "futures" markets. The same way that commodity futures contracts are generally higher the more forward you go. This article basically explains trading an interest rate spread, the same way you would trade a calendar spread in commodity contracts.

What I am asking is probably a whole lot more basic and easier, and for some reason I have just forgotten it and can't seem to explain it right now.

I'll try to explain it as clearly as I can.

The US fed funds rate is .10 (fed website)
The Aussie buy premium is 2.15 (my broker)

This means that the aussie central bank rate must be 2.25 (x - .10 = 2.15)

So, when I hold my money in USD at my bank, and I am not buying a bond, I am subject to the interest I am given at the firm with the deposits, which then bases their interest rate off the fed funds rate. Now BankofAmerica will currently pay me a whole whopping .01% on my money.

Now when I trade forex, I get full exposure to the interest rate, so what is really happening? Say I buy AUD/USD, so I just sold some USD to buy some AUD.

 

  1. Somebody is taking my newly acquired AUD and keeping it somewhere and lending it to other people and fetching somewhere around the base rate set by the aussie central bank.
  2. Who is doing this for me? Why are they doing all the legwork? They're doing all this free of charge to me? Is all of this actually happening, or is it more of an agreement between banks/brokers that these interest rate differentials will be paid based on foregone interest that could be earned by that money?
  3. What happens to the USD I sold? And why is my broker telling me that the sell premium to sell AUD/USD is -5.2%?

I think I've taken it for granted for a while what these numbers do to my trades, but I want to know why the exist and what is happening behind the scenes to put them in place.

  • #12
  • Jun 6, 2014 1:09pm Jun 6, 2014 1:09pm
bump, anyone???
  • #13
  • Jun 6, 2014 4:00pm Jun 6, 2014 4:00pm
All your trades are virtual, you open an account in USD and your funds stay as USD. Your account balance is then adjusted up or down as if currencies were bought or sold even though no real buying or selling take place for you (the broker may hedge it's net position but that is for their account not yours). The broker makes a big mark-up on swap rates - they want customers who trade rather than buy/sell and hold, so they make sure there is a profit margin for the latter types. So your swap rate cost is always greater than the currencies actual interest rate differential.
  • #14
  • Jun 7, 2014 2:02am Jun 7, 2014 2:02am
Quoting fxwise
All your trades are virtual, you open an account in USD and your funds stay as USD. Your account balance is then adjusted up or down as if currencies were bought or sold even though no real buying or selling take place for you (the broker may hedge it's net position but that is for their account not yours). The broker makes a big mark-up on swap rates - they want customers who trade rather than buy/sell and hold, so they make sure there is a profit margin for the latter types. So your swap rate cost is always greater than the currencies actual interest...
thanks fxwise, I was wondering if anyone could expand on this some more. I am not sure what else there is to say, but I would like all the info I can get. How are brokers allowed to do that by making virtual trades only? Wouldn't that just make them a glorified bucket shop?

So the swap rates are up to the broker, meaning that every broker will have different rates? Is there anywhere I can see all the rates for different brokers?

And just to be clear, simply holding a currency will not let you earn the interest rate, other than the effects the central bank interest rate might have on exchange rates, right? The only way you get any effects of interest rates would be to loan the money out via a note or bond or bank account, correct?
  • #15
  • Jun 7, 2014 4:19am Jun 7, 2014 4:19am
I don't think there is anywhere which compares the swap rates of different brokers. The majority of traders are short term, often day traders, so it is not a significant issue in their choice of broker. On Metatrader you can usually right click in the market watch area, select symbols and on the particular symbol press the Properties button to see the contract specification including the swap long and swap short values. This does not always display all of the information - in which case some MQL4 code using the MarketInfo function gets this data. Values are usually a multiple of the point value (usually 0.00001). Values do vary quite a lot. On AUDUSD at 3 different brokers I see swap longs of 5.6 4.38 2.34 and corresponding swap shorts of -7.3 -9.27 -3.38

You can earn the interest differential when the swap rate is positive. But the broker is making a profit margin on it (charging one side more than he is paying on the other side). For many low interest currencies (usd, eur etc.) both the long and short swap rates will be negative.
  • #16
  • Jun 8, 2014 2:50am Jun 8, 2014 2:50am
Quoting TranceTrader
As you've found out... this isn't a straight forward question to answer. The carry/swap/roll-over is basically the overnight swap rate(swaps are derivative contracts) for the equivalent synthetic FX swap position.. due to your broker automatically deferring the value(delivery) date on your spot position. To understand how FX swaps work and how they are priced (to determine the swap cost/credit when you buy/sell) have a read here http://www.forextraders.com/forex-st...rex-swaps.html The swap differential is affected...
Sorry I somehow missed your post here. I know that fed funds rates arent exact but I thought it would be close enough to the interbank rates. I read the article and I think I understand it, so it seems like this is what is happening...

 

  1. My "spot" forex trade is actually a swap which functions like a future, with a near term (tomorrow?) settle date.
  2. The broker takes the trade and hedges off their risk by trading the opposite way on a swap (future?) trade a little longer out in time.
  3. The spreads between these short calendar spreads which is basically just the risk free rate of return, is where my carry comes from
  4. This way no actual currency has changed hands or is lent out to receive interest, its just all being marked to market like a futures contract?

Does this seem pretty accurate, am I wrong anywhere here?

  • #17
  • Last Post: Jun 8, 2014 5:42am Jun 8, 2014 5:42am
Pretty accurate, yes. The broker would usually hedge on the spot market for part of their exposure only when it exceeds their risk limit. Otherwise it is in their interest to take the other side of all retail trades (as retail traders usually lose in the log run). Different settlement dates for their hedge and their customer's positions don't matter as customers can usually only withdraw in the same currency they deposited with. Although it is all virtual the customer gets the same effect as if he were trading on the spot market, minus the broker's profit margin, but he can also trade much smaller size than would be possible in the "real" market.
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