One of the terms which are harder to understand, especially when it comes to beginning forex traders, is the swap rate. If you are trading forex and if you are holding a position more than a day, you’ll notice that your broker charges you with a rate, which can be positive (meaning you are earning interest) or negative (you have to pay the broker a specific amount). Even though the swap rates are generally low and might seem insignificant, a thorough understanding is still necessary.
What is a swap rate?
As we’ve discussed in an article about forex terminology, in forex you are using leverage. What this means is that you are borrowing money from your broker, in exchange for a deposit that you make. Since the money is borrowed, an interest rate is also there. All brokers work with banks in order to meet liquidity requirements and thus they need to pay interest.
When it comes to swap rates, we need to discuss first the benchmark rate any central bank has. It is basically the rate at which all commercial banks from a given country, can have access to funding.
For trading forex, brokers are linking the swap rates to benchmark rates differential. Let’s take an actual example. At the time of writing the European Central Bank has an interest rate of 0.0%. On the other hand, the Federal Reserve, which is the central bank of the United States, has an interest rate of 1.75%.
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If we take the EURUSD pair, then if you short the pair (that means you are selling euros and buying US dollars) 1.75-0= 1.75. That means the result is positive and you will have a positive swap rate, so you will earn interest for every day you are holding the position open.
On the other hand, if you are buying the EURUSD you will lose a fixed amount for each day you are holding the position open.
Swap rates can be significant especially when it comes to higher volumes. If you have a large amount of capital, managed to overcome the fear of trading and are sure longer term trading is suitable for you, then swaps can really generate an extra revenue.