Calculating Interest on Forex Trades

One of the best things about Forex trading is the fact that one can trade using leverage, thus borrowing as much as 1,000 times your capital in order to make a trade. However, borrowing money for trading in foreign exchange is the same as borrowing it for other purposes—interest must be paid on the loan. However, as currency trading involves both buying and selling, the interest due on your loan can be offset by the interest earned on the currency you buy. Before going on to particular examples, let us take a look at interest rates in general, to see how the foreign exchange market is affected by it. In central banks, interest rates are set in accordance with a country’s monetary policy—high interest rates make the currency more expensive to buy and lower interest rates make it less so. Imagining the government of a country with high inflation will help you understand how interest rates are used. The government, because of rapidly rising prices, might decide to raise interest rates. This would increase the cost of the country’s currency, and make demand and consumption fall, as borrowing would be more expensive. This in turn would cause prices to fall and inflation rates would come down. Similarly, a country undergoing recession might lower interest rates to boost the country’s economy, as lower price of currency would cause demand, and, therefore, supply, to increase. Interest rates set by central banks also determine at what rate commercial banks can borrow from governments and lend to their customers, including forex traders. Which tells us how interest rates affect this trade. A trader who, for example buys GBP/USD, needs to borrow the Dollars to buy the Pounds and will, thus, pay interest on the USD and earn it on the GBP. If the interest rate the Bank of England sets for the UK Pound is higher than the one set by the Federal Reserve for the US Dollar, the trader will earn more on the UK Pounds he bought than he pays on the US Dollars he borrowed, thus making a profit.
©
Forex Trading Strategies
31
However, unless there is a significant difference between the two interest rates, the net profit or loss will be marginal. Besides, while interest rates are set on an annual basis, trading positions are usually opened for short periods. This serves to significantly lower any gain or loss on interest rates.