Rollovers or Swaps

Before we discuss this topic, it is necessary to say that Forex Place 4xp performs all the rollovers automatically, and there is no need for trader intervention. However for an understanding of the mechanisms of the rollover or swap please read on.

Before we discuss rollovers, we need to discuss Spots in more detail. Whenever there is an inter-bank foreign exchange transaction traded, delivery must take place two business days form the deal date.

OK, lets explain this a little more clearly; traditionally when foreign exchange trading was used predominantly by hedgers, banks needed enough time to make the necessary transfers of funds, one to another, particularly when taking into account the time differences around the world. This can best be shown by an example:

Say there are two banks that wish to trade with one another, the first bank A Bank is based in Sydney Australia, the second B Bank is based in NY, in the US.

“A Bank” calls “B Bank” to buy 1 mio EUR/USD, the price is agreed at 1.3431. Now “A Bank must transfer 1 mio EUR and receive 1,343,100 USD on the same day.

Because of the time difference between the two countries (this can range between 14-16 hours depending on the time of the year), banks agreed that all transfers would take place two business days after the trade date. The first question is what is the trade date?

Since countries can have a 16 hour difference between them they could both be trading on different days. This is why all the times and dates are measured according to GMT or Greenwich Meridian Time, or in other words 22:00 London time. This is where most FX trades are traded and so is the FX centre of the world.

Since all trades done are delivery trades, actual funds must be handed over, a solution needed to be made for clients wishing to speculate on the movements of the currencies without having to physically pass over and receive the funds traded.

Particularly since most speculative trades – which as mentioned earlier make up approximately 85% of the total Forex market, and most of these trades are made using leverage it is not realistic to expect actual delivery of funds.

For instance if a client deposited 10.000 Euro in his account and bought 1million EUR/USD, he really does not want to receive 1 million EUR in his account in two days and be debited over 1.3 million USD…

If a trader executes a trade we know that the trade must be delivered in two working days. However if he closes the trade (trades an opposite deal) in the same day, then the second trade must also be delivered in two working days. Lets revue how this would appear in the client’s balance sheet.

Example 1

Let’s say that a trader bought 1 million EUR/USD at 1.3400 on the 1st of May 2007 at 10 am GMT and sold 1 million EUR/USD at 1.3370 on the 1st of May 2007 at 11am GMT.

Date Traded Value Date (Delivery Date) EUR USD
01/05/2007 03/05/2007 +1,000,000 -1,340,000

01/05/2007 03/05/2007 -1,000,000 +1,337,000
Transfer Date 03/05/2007 0 -3,000

From the above we can see that the only transfer necessary is negative $3,000 from the clients account since the Euro’s cancel themselves out and the USD cancel themselves out except for the residual balance.

So in the case where a client closes his trade on the same business day as he opened them, there is no need to do anything since the broker will net off the amounts and the net balance will either be added or deducted from his account in two business days.

What happens if the trader does not close out his trade on the same day opened?

This is where rollovers or swaps come in.

Example 2

Let’s take the same example as before except say that the closing trade was performed one day later, on the 2nd of May 2007. Let’s review the balance sheet again:

Date Traded Value Date (Delivery Date) EUR USD

01/05/2007 03/05/2007 +1,000,000 -1,340,000
Transfer Date 03/05/2007 +1,000,000 -1,340,000

02/05/2007 04/05/2007 +1,000,000 +1,337,000
Transfer Date 04/05/2007 +1,000,000 +1,337,000

From here we see that we have a small problem of timing, even though the trade is closed the trader will have plus 1 million Euro in his account and minus 1,340,0000 USD in his account for a full day before it gets solved the next day on the 4th of May 2007.

To make life easier and avoid this problem, the banks introduced the rollover or swap and the online brokers essentially work in the same way. The trader does not need to anything as all of the rollovers are automated.

This is how it works. The banks figured out that what the trader really needs is to close the opening trade right at the close of business day and to reopen it right at the start of the next day. This is done at 22:00 GMT when the official day changes. This type of rollover or swap is also known as a T/N or Tom/Next trade (tomorrow to the next).

Let’s see how this works.

Example 3

As we saw from example 2 from above, we have a timing problem, the rollover takes into account the interest rate differentials between the two currency pairs and calculates the monetary value per day, and either charges the trader for holding the lower yielding currency or reimburses the trader for holding the higher yielding currency.

Once this is done the open trade works in exactly the same way as if it were opened in the current day.

If we reflect back to example 2 we see that the client is long 1,000,000 EUR from the 3rd of May 2007 until the 4th of May 2007 and short 1,340,000 USD from the 3rd of May 2007 until the 4th of May 2007. On the 4th of May the situation is rectified by closing of the deal.

In order to fix the problem the trader really needs to deposit the EUR for one day and loan the missing USD for one day. This is essentially what the rollover does. It is a deposit and a loan.

However as we know currencies are not all the same, and each currency has its own deposit and loan rate that is updated by the local government from time to time as a part of its monetary policy.

In this case on the 1st of May 2007 the EUR interest rate was 4% as posted by the European Central Bank, and the USD interest rate was 5.25% as posted by the Federal Reserve Bank.

There is usually a quarter percent difference between deposit and loan rates so the rates would likely be as follows:

EUR Deposit 3.75%, EUR Loan 4.00%, USD Deposit 5.00%, USD Loan 5.25%

In this case the trader would deposit the EUR at 3.75% and take a loan in USD at 5.25%.

The formulae for calculating the cost or receipt of the rollover is as follows:

Pips = ((Spot*(1+((Number of Days/360)*R2))/(1+((Number of Days/360)*R1)))-Spot)*10000

Where:
Pips = Total number of pips for the rollover or swap
Spot = The Current spot rate
Number of Days = Number of Days for the rollover
R1 = The major currency interest rate
R2 = The secondary currency interest rate
0.558 = ((1.3400*(1+((1/360)*0.0525))/(1+((1/360)*0.0375)))-1.3400)10,000
Therefore the cost of the rollover would be 0.558 pips or in dollar terms:
1,000,000*0.0000558 = 55.80 USD.

Therefore the real way that the trader’s balance sheet would appear would be as follows:

Example 4

Date Traded EUR USD
01/05/2007 +1,000,000 -1,340,000
02/05/2007 -55.80
02/05/2007 -1,000,000 +1,337,000
02/05/2007 0 -3,055.80

In the example given the rollover points went against the trader, however had the trader started off by selling the EUR/USD instead of buying then the points would have been in reverse and he would have received a rollover amount, in this way there is no detriment to the trader

The use of rollovers or swaps is a very efficient way of allowing traders to decide when to close off their trade without having any time pressures. It is a much more efficient mechanism than the use of forwards.

Islamic Accounts and Rollovers
Some members of the Islamic community wish to trade in FX however do not wish to have anything to do with rollovers since they are based on interest differentials. It should be noted that Forex Place caters for such accounts for legitimate purposes only.

Islamic accounts work in the following way, all the rollovers or swaps use zero interest rates for all the currencies whether they are for deposits or loans. In this case there is no interest rate trading at all in these accounts.

These accounts are offered on a good will basis to the Islamic community, for in theory a holder of an Islamic account can use this to his advantage and arbitrage between two accounts, one regular and one Islamic. At Forex Place we cater to the Islamic community, although the accounts are monitored to ensure that there is no misuse.