Interest Rate Differentials

Carry's fuel. Policy can reverse it.

Expert 6 min read Course 51 of 60

Course 51 of 60 in the forex hub. The gap between two countries' interest rates turns up as a swap line on a spot statement. I'll show how it's figured and why I don't think it's a good reason to size up.

What the gap is

If you hold a currency pair overnight, you're long one currency and short the other, and each has a policy rate behind it. The differential is the rate on the currency you're long minus the rate on the one you're short. When it's positive, your dealer may pay you a little each night. When it's negative, you pay. A gap like that can lean the same way for years, which is exactly why people start treating it like a savings account.

A central bank meeting can change the gap overnight, and that gets its own lesson. Listed currency futures, which the futures course covers, have no nightly swap line at all. A dealer account pays or charges it every night instead, and that nightly line is where people start fooling themselves.

Write the gap as one number

Before you put on a position for the carry, write the differential down as a single figure, long rate minus short rate, with the date next to it. The chart can drift against you for weeks while that number stays put, and it's easy to confuse the two.

Then write three more things: what you expect the gap to do, what would tell you you're wrong, and how many dollars you'd lose if it closed fast. On a major pair, U.S. retail forex rules require a security deposit of at least 2% of the position's value, which is where the 50:1 ceiling comes from, and if your deposit falls short the dealer has to collect more or close you out. The margin calculator shows what a given leverage setting ties up.

A differential is two policy rates. Carry's fuel. Policy can reverse it The fuel i_home − i_foreign (sketch)Shows up in swapCan persist for years The reversal A meetingA shockYears of coupon, days of unwind

Where swap shows up

Swap is the nightly charge or credit for holding the position, and it's built from the rate gap plus the dealer's markup. That markup matters more than people think. A pair with a positive gap can still show a small debit every night once the dealer takes its cut. Many dealers also book three days of swap at the Wednesday rollover to cover the weekend, so Wednesday's line looks bigger than the rest.

Round figures: $100,000 of EUR/USD at 50:1 ties up a $2,000 deposit. Swap is figured on the whole $100,000, so a 3% gap is roughly $3,000 a year before markup, about $8 a night ($3,000 / 365 = $8.22). A 150-pip move against you costs 100,000 x 0.0150 = $1,500, half a year of that credit.

Six months of collecting can disappear in one move against you, and the credit does nothing to stop it.

Swap is differential plus markup — the statement is the truth swap ≈ f(rate differential) + dealer markup Positive carry can still be negative after markup Triple Wednesday three days of the line If swap is the trade you are in carry — size crash Look at the statement not a tweet

Quiet months, then a fast close

Most of the time carry is dull. You get small credits, the pair drifts, and there's not much on the calendar. Then a meeting, an inflation surprise, or a change in what traders expect from the next few meetings closes the gap, and a long quiet stretch ends in a few hard days.

The danger is in the quiet part. When the credits keep coming, size creeps up because the money starts to feel like rent. I'd write down the loss I can live with while the credit is still boring, because I won't be thinking straight about it once the pair is moving.

Policy can reverse the differential in a session quiet carryaccrualrepricingfront-endmeetingthe printunwindgap risk

Treat the gap as background

I keep the differential in my journal whenever I hold a pair, because it tells me what holding costs or pays. What I don't do is let it be the reason for the trade. A small position that leans the same way as a view I already have is fair. Taking maximum leverage so the swap looks like an income is how accounts get emptied.

The same note should hold the stop, the rule for getting flat, and any session you won't hold through. If your stop is a price level, turn it into dollars once you know what a pip is worth on that pair, and check that figure against the loss you wrote down.

Is the differential a reason to hold, or just a journal line? Crash budget written? Tiny overlay ok context Do not harvest 50:1 for swap

Why I don't call it yield

Calling swap a yield makes it sound safe, and it isn't. Nothing protects the money you put up, the pair can gap, and the dealer's markup comes out every night. On a short hold the credit can easily be smaller than the spread you paid to get in.

Here's a test I like. Cover the swap column and look at the trade again. If you'd close it, the rate was the only idea you had. Swap rates change too, so read your dealer's current swap sheet before you add size. How big your loss budget should be is covered in the lesson on advanced risk.

This is not a savings APY. Calling it yield is how people max the slider Not yield No principal guarantee.Gaps exist.Dealer markup exists.Size as crash, or skip.

A year of credits, one bad week

The classic mistake here is collecting carry for months on a position that's too big, with no plan for the day the gap closes. When it goes, it tends to go quickly, and one week can take back what a year paid. The meeting that usually starts that kind of move is the subject of the central banks lesson.

So decide the loss before that week comes, while it's still just a number on paper. And when your notes and the dealer's statement disagree about what you were paid or charged, go with the statement and find out what you missed.

The coupon is small. The unwind is not months of swap looks like 'income' one unwind week can erase the year 50:1 on that account event

Expected gaps move the pair

Today's gap shows up in tonight's swap. The pair itself often follows what traders think the gap will be over the coming months. Going long the higher-rate currency because of today's gap is a different bet from expecting that gap to widen, and the two can pull in opposite directions.

Expectations shift at meetings and on inflation reports, and a narrowing can happen fast. If the gap was your only reason for holding, that reason is gone once expectations change, even if today's rates haven't moved.

What to write down

  • The differential is the rate on the currency you're long minus the rate on the one you're short.
  • Swap is that gap plus the dealer's markup, so a positive gap can still cost you.
  • Check Wednesday's line on your own statement.
  • Write the loss you'd take if the gap closed, before the credit starts to matter to you.

If that last number is still blank, the gap belongs in your journal and nowhere near your position size. Educational only. Not a recommendation to buy, sell, or hold any contract or pair.