Interest-rate differentials, overnight swaps and the carry trade

What you will learn

• Why holding a currency position overnight earns or costs interest, and how a broker turns this into a swap.
• How to estimate a daily swap and why the long and short sides are not symmetric.
• What covered interest parity and forward points say about "free" interest income.
• How a carry trade works, and why a small price move can erase months of carry.

Explanation

How central banks set policy rates was covered in the course "Macro" (lesson "Interest Rates and Central Banks"). Here we look at what the difference between two rates does to a currency position.

Why a position earns or pays interest

Buying EUR/USD means you are, economically, holding euros and owing dollars. Spot trades normally settle two business days later (T+2; USD/CAD settles T+1). A retail position is never delivered, so each day at rollover the broker "rolls" it forward, using the tom-next rate (the cost of swapping a position from tomorrow to the next day). The result is the swap or overnight financing: you roughly receive interest on the currency you hold and pay interest on the currency you owe.

Estimating the swap

A simple approximation: daily swap ≈ position value × (rate of currency held − rate of currency owed − broker markup) ÷ 365. Brokers add a markup (an extra charge) to both sides, so the side with the positive differential receives less than the raw difference, and the other side pays more. With small differentials, both sides can be negative. Because of T+2 settlement, many brokers book three days of swap on one weekday (often Wednesday) to cover the weekend. Your broker's swap table is the only figure that counts.

Covered interest parity and forward points

Covered interest parity is the no-arbitrage rule that links spot and forward rates: forward = spot × (1 + i(quote) × t) ÷ (1 + i(base) × t), where i is the interest rate and t the time in years. The difference between forward and spot, expressed in pips, is called forward points. The high-interest currency trades at a forward discount, exactly enough to offset the interest gain. So if you lock in the future exchange rate, the interest advantage disappears.

The carry trade

A carry trade means buying a high-interest currency against a low-interest currency without hedging, hoping that the exchange rate stays stable or moves less than the forward discount implies. Economists call the idea that it should not work on average uncovered interest parity. In history, this idea has often failed for long periods, which made carry profitable for a time, but carry trades have also suffered sharp, fast losses in risk-off episodes, for example in 2008 and in August 2024 when many yen-funded positions were closed at once. Carry tends to earn slowly and lose quickly.

Worked example

Hypothetical example: long 100,000 AUD/JPY at 100.00. Assumed rates: AUD 4.00%, JPY 0.50%; broker markup 1.00 percentage point. Under the EU retail limits covered in the course "Risk Management" (lesson "Leverage and Margin Explained"), a non-major pair like AUD/JPY needs at least 5% margin. Spreads, taxes and changes in rates are excluded; values are rounded.

1. Raw differential: 4.00% − 0.50% = 3.50%. Net after markup: 3.50% − 1.00% = 2.50%.
2. Daily swap received: 100,000 × 2.50% ÷ 365 ≈ AUD 6.85. On a triple-swap day: 3 × 6.85 ≈ AUD 20.55.
3. Over one year (if nothing changes): 100,000 × 2.50% = AUD 2,500.
4. Margin: 100,000 × 5% = AUD 5,000. The carry looks like 50% per year on margin, which is exactly why it is dangerous.
5. Break-even price: the yearly carry is lost if 100,000 × (100.00 − x) ÷ x = 2,500, so x = 10,000,000 ÷ 102,500 ≈ 97.56, a fall of only about 2.4%.
6. One bad day: a 1% fall costs about AUD 1,000, roughly 146 days of carry (1,000 ÷ 6.85).
7. The short side would pay 3.50% + 1.00% = 4.50%: 100,000 × 4.50% ÷ 365 ≈ AUD 12.33 per day.
8. Forward check: one-year forward ≈ 100.00 × 1.005 ÷ 1.04 ≈ 96.63. The market's forward rate already "expects" a fall of more than 3%.

Common mistake

Practice activity

On paper: you are short 50,000 EUR/USD. Assumed rates: EUR 2.00%, USD 4.00%, broker markup 0.80 percentage points. (1) Do you receive or pay swap, and roughly how much per day? (2) What would the long side pay or receive? (3) How many days of swap does a 0.5% adverse move cost?

Key takeaways

• Overnight swap reflects the interest differential minus a broker markup on both sides.
• Covered interest parity means a hedged position earns no extra interest: forward points remove it.
• An unhedged carry trade is a bet that the high-yield currency will not fall more than the forward discount.
• Calculate how many days of carry a normal adverse move costs before entering.

Next step

In the next lesson you will look at purchasing power parity and how economists judge whether a currency is cheap or expensive in the long run.