What is a Forex swap ? (Part 2)

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What is the carry trade？

When market conditions are right, traders often take a position actively in a currency with the highest corresponding interest rate, and “fund” the transaction by short selling a currency with a lower interest rate, then deduct the positive interest differential. This is called the carry trade. In fact, trader keeps his position to recover the differential between interest and swap rate. The carry trade technique is an important part of the Forex landscape and can be a primary consideration for many hedge funds.

Why do brokers charge swap fees？

At some brokers, they provide their clients with the ability to trade price changes actively in global currency markets without having any interest in taking physical delivery of the traded currency. So when we enter a leveraged Forex position, it is an open and indefinite settlement in fact. This means that as a trader, you decide when you want to close a position by using a stop-loss, or other form of position management, and as a counterparty, brokers use the rollover times to calculate finance charges instead of delivery or receipt of physical currency.

How does settlement in the underlying currency spot market work ？

In the underlying market, spot forex trades tend to settle two business days after the trade date (T+2). If an institution buys EUR/USD on the spot foreign exchange market, it will receive EUR at the agreed rate two days after the trade day. There are some exceptions to this rule, for example, USD/CAD which settles on the day after the trade day (T+1).

What is a Tom/Next？

Tom/Next swaps are fully tradable financial instruments. Their rates fluctuate on the basis of expectations of monetary policy and other forces, such as supply, demand and liquidity, which influence the market. Institutions often seek to delay settlements by entering into a Tom/Next.

Example of a Tom/Next swap

Suppose a trader buys a EUR/USD contract (with a notional value of €100,000), but for some reason, he wants to delay settlement for a day. The next day, the counterparty exchanges the €100,000 again with the trader for the following day (“Next”) at the rate of previous transaction, plus the Tom/Next market rate. Therefore, the settlement is postponed for one day, the trader's exchange rate is actually adjusted for the Tom/Next market exchange rate.

Some brokers are replicating this process exactly because of the way they manage their client flows with their hedge banks. This means that the cost (or credit) of the rollover and postponement of the settlement is replicated to your account. If you decide to hold a position after the rollover time of 5:00 p.m. New York time (or 7:00 a.m. Eastern time), you will pay or earn the Tom/Next fee on your nominal position, including any profit or loss.

Please note that in the physical world of Forex, the previously agreed opening price is adjusted according to swap rate. In leveraged Forex trading, there is a simple cash adjustment to your account

(To be continued ... )