A:

In the forex market, all trades must be settled in two business days. Traders who want to extend their positions without having to settle them must close their positions before 5pm Eastern Standard Time on the settlement day and re-open them the next trading the day. This pushes out the settlement by another two trading days. This strategy, called a rollover, is created through a swap agreement and it comes with a cost or gain to the trader, depending on prevailing interest rates.

The forex market works with currency pairs and is quoted in terms of the quoted currency compared to a base currency. The investor borrows money to purchase another currency, and interest is paid on the borrowed currency and earned on the purchased currency, the net effect of which is rollover interest.

In order to calculate the rollover interest, we need the short-term interest rates on both currencies, the current exchange rate of the currency pair and the quantity of the currency pair purchased. For example, assume that an investor owns 10,000 CAD/USD. The current exchange rate is 0.9155, the short-term interest rate on the Canadian dollar (the base currency) is 4.25% and the short-term interest rate on the U.S. dollar (the quoted currency) is 3.5%. In this case, the rollover interest is $22.44 [{10,000 x (4.25% - 3.5%)}/(365 x 0.9155)].

The number of units purchased is used because this is the number of units owned. The short-term interest rates are used because these are the interest rates on the currencies used within the currency pair. The investor in our example owns Canadian dollars, so he or she earns 4.25%, but must pay the borrowed U.S. dollar rate of 3.5%. The product of the difference in the numerator of the equation is divided by the product of the exchange rate and 365 because this puts our numerator into a daily figure. If, on the other hand, the short-term interest rate on the base currency is below the short-term interest rate on the borrowed currency, the rollover interest rate would be a negative number, causing a reduction in the value of the investor's account. Rollover interest can be avoided by taking a closed position on a currency pair.

To learn more, see Getting Started In Forex and Floating And Fixed Exchange Rates.

RELATED FAQS
  1. What are the goals of covered interest arbitrage?

    The goals of covered interest arbitrage include enabling investors to trade volatile currency pairs without risk as well ... Read Full Answer >>
  2. What are the main risks associated with trading derivatives?

    The primary risks associated with trading derivatives are market, counterparty, liquidity and interconnection risks. Derivatives ... Read Full Answer >>
  3. Should you calculate Value at Risk (VaR) for counterparty credit risk?

    Value at risk (VaR) calculations may be helpful for risk management when trading credit default swaps and other derivatives ... Read Full Answer >>
  4. For what financial instruments is a modified duration relevant?

    The modified duration is a formula used to calculate the percent change in the price of a financial instrument when there ... Read Full Answer >>
  5. What is the difference between derivatives and swaps?

    Derivatives are securities with prices dependent on one or multiple underlying assets. Common derivatives include forward ... Read Full Answer >>
  6. Why is tenor important on credit default swaps?

    Tenor – the amount of time left on a debt security's maturity – is important in a credit default swap because it coordinates ... Read Full Answer >>
Related Articles
  1. Forex Strategies

    Two Great Currencies To Profit From Oil Volatility

    U.S. dollar crosses with Canadian and Australian dollars offer easy access to crude oil trends due to their tight correlation with energy futures.
  2. Mutual Funds & ETFs

    ETF Analysis: ProShares UltraPro Short S&P500

    Find out information about the ProShares UltraPro Short S&P 500 exchange-traded fund, and learn detailed analysis of its characteristics and suitability.
  3. Investing Basics

    5 Tips For Investing In IPOs

    It’s not easy to profit from IPO​s, but the money is there.
  4. Forex Strategies

    These Are The Best Hours To Trade the Euro

    Six popular currency pairs and numerous secondary crosses offer euro traders a wide variety of short- and long-term opportunities.
  5. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  6. Forex Strategies

    Benefits & Risks of Trading Forex with Bitcoin

    Want to trade forex using bitcoins? Don’t jump on the bandwagon until you compare the risks to the benefits.
  7. Forex Strategies

    How To Trade Forex With Bitcoin

    We look at ways to trade forex with bitcoin and the pitfalls in doing so.
  8. Forex Fundamentals

    Chinese Yuan an Unlikely Reserve Currency

    As the world's second largest economy, China's challenge to America’s dominance includes a push to make the yuan (RMB), the world’s reserve currency. Whether it can do that now is unclear.
  9. Mutual Funds & ETFs

    UCO Vs. UWTI: Two Different Leveraged Oil ETFs

    Find out more about the ProShares Ultra Bloomberg Crude Oil ETF and VelocityShares 3x Long Crude Oil ETN, and the mechanics and differences of these funds.
  10. Mutual Funds & ETFs

    UGAZ Vs. GASL: Two Different Leveraged Gas ETFs

    Find out more about the VelocityShares 3X Long Natural Gas ETN and the Direxion Daily Natural Gas Related Bull 3X ETF and the differences between these ETFs.
RELATED TERMS
  1. Plain Vanilla

    The most basic or standard version of a financial instrument, ...
  2. Derivative

    A security with a price that is dependent upon or derived from ...
  3. Transfer Risk

    The risk that a local currency cannot be converted into the currency ...
  4. Reference Equity

    The underlying equity that an investor is seeking price movement ...
  5. ICE LIBOR

    See LIBOR
  6. WM/Reuters Benchmark Rates

    Spot and forward foreign exchange rates that are used as standard ...

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!