We have already clarified that margin trading supposes the usage of the loan capital, when a trader borrows assets from his broker to carry out operations on Forex. For better understanding of this chapter, let us study the principle of cash assets turnover in the state. Imagine that a new state is formed. There is a working-age population, but there is no money in the state yet, so what to do in this case? The Central Bank of our virtual state entrusts the Mint to issue the banknotes of the standard pattern. Suppose that the banknotes are issued, but how are they distributed among the population? The number of commercial banks emerges in the state to borrow from the Central Bank. The credit, as we know, is not granted without special purpose, the interests for the credit should be paid in any way. This is the key moment of monetary policy formation. The Central Bank fixes the interest rate, on which the commercial banks are credited. In different countries such a rate is called differently. In Russia it is called refinance rate (interest rate). In other countries it can be called interest rate, base rate, key rate, etc. However, let’s get back to our virtual state. Now the commercial banks have money, and they, in their turn, start to grant loans to organizations at a higher interest than the refinance rate. In this way, the commercial banks gain profit from the difference between rates on credit. Organizations arrange business, hire employees, and pay them salaries. As a result of business processes in organizations goods are produced (or services are provided). The organizations get profit and payback the borrowed assets and interests to the commercial banks. The commercial banks, in their turn, payback the credits to the Central Bank. As a result, money is distributed through the state. Of course, this is a very simplified scheme, but very important for study of borrowed capital trade on Forex.
The interest rate is one of the major regulators of the inflation rates. The inflation is the quantitative growth of the cash assets in circulation. In other words, when the number of banknotes in circulation increases, one can buy more goods for them. In this situation the organizations try to increase prices for goods and services, as a result money falls in value. In order to slow the growth of inflation, it is necessary to decrease the amount of cash assets in circulation. Thus, the state hikes the interest rate. The rise of the interest used to curb inflation, at first sight, is not evident. The higher the interest rate is, the higher the interest on the credits granted to the organizations by the commercial banks will be. As a consequence, the organizations incur fewer debts, the production slows down, the salary is paid in lesser amounts, and, as a result, the quantity of cash assets in circulation decreases. As a side effect of this “interference” the level of unemployment increases in the state because of production cutback. In this case, we can see that all processes in the state are interrelated.
Why does a trader need all this? Let us consider an example, when we intend to buy the US dollars for the Japanese yens. We open an account for $1,000 with a broker. We have already discussed that the principle of margin trading allows us to buy the dollars for the yens, even if we do not have the yens. However, we should understand that we borrow these yens from the broker! We buy dollars for them (the broker purchases them for us). One more important moment, the bought dollars remain at the broker's; we do not dispose of them. The only thing that we can do is to sell these dollars back for the yens, i.e. to close the position with profit or loss. This means that the broker owns the bought dollars. In other words, we lend them to the broker.
We have already discussed that if we borrow assets, we should pay the corresponding loan rate. Since all the deals on Forex are made at the inter-bank level, the interest rate, which is fixed by the Central Bank, is used. At that, if we have already borrowed the US dollars, we pay back the interest rate fixed by the U.S. Central Bank (Federal Reserve Bank). If we borrow the Japanese yens, then we pay back the interest rate fixed by the Japanese Central Bank (Bank of Japan). In different countries the different interest rates function.
The interest rate is represented in an annual interest rate in percent (%). For instance, if the interest rate in Japan is 0.5% and 0.3% in the USA, it means that for the Japanese yens borrowed from the broker we have to pay 0.5% per annum from the sum of the credit. On the other hand, the broker pays 3.0% per annum for the US dollars borrowed from us. Note that this principle works only if the opened long position on USD/JPY is not closed during a couple of days. It means that the interests are counted every day on the open positions! If we close position the day when we have opened it, then the interest rates are not taken into account. Suppose our position was opened during one month and at the end of the month we decided to close it. For simplification suppose that BID price is equal to ASK price, the USD/JPY rate was almost unchanged for the month. We did not earn on the difference between the rates. What about credits? We have to pay the broker 0.5% per annum monthly, i.e. about 0.5% / 12 = 0.04% of the borrowed amount. We should pay this sum in the yens, but all the calculations are converted to the currency of our account, in this case - the U.S. dollars on the selling rate in USD/JPYt quotation. The broker should pay us 3.0% per annum per month, i.e. 3.0% / 12 = 0.25% of the borrowed sum in the dollars. We should understand that the borrowed sum, which we owe in the yens, and the sum which is lent to us in dollars, are equivalent to the volume of the opened position, i.e. the volume of one lot, mini lot or micro lot, depending on the lot volume we use. Suppose, that the position was opened with one mini lot (1 mini lot is equal to $10,000). Then, in our example we will earn on the difference between interest rates 0.25% - 0.04% = 0.21% of the volume of mini lot, i.e. about 10,000 * 0.0021 = $21.
It should be taken into account that if we opened a short position on the US dollar (were selling the dollars for the Japanese yens), then we would lose $21 on the difference between the interest rates. Whether you earn or lose on the difference between the interest rates depends on the traded currency and the type of the opened position (long or short). The sum paid on the interest rate is the bank interest. In the margin trading the bank interest is always earned on the currency, which is bought and paid in the currency for which is sold.
As we can see, it is possible to earn on Forex not only on the currency rate fluctuations, but also on the difference between the interest rates. The type of trading which assumes earning on the difference between the interest rates, called carry trading. Not all brokers pay the bank interest, there are some which benefit from the interest rate, but never pay it back. The current interest rates of some brokers may differ from the rates fixed by the Central Bank of the corresponding countries, and also may change with the course of time. That is why it is better to consult the broker on the question of bank interest payment before you open the account with this broker! Having opened a position, you should understand clearly the components of your income and spending, in order not to open a certain losing position or not to close it with losses. In this case the position should be closed in the way that it will cover spreads and spending on the bank interest.
The concept of the bank interest and interest rate may embarrass the newcomer, that is why if you do not want to sort out these notions, do not leave your positions overnight. Use the exclusive strategy of the day trading. If the position is opened and closed within one day, then the bank interest will not be considered.
We have already discussed that there is no active trading on Forex on holidays and weekends. That is why the bank interest can be counted unevenly during the week. This means that the bank interest is not counted on holidays, and the corresponding part of it is distributed through the week days. Taking into account that there are 7 days in a week, we can have the situation, when for Monday, Tuesday, Thursday and Friday the bank interest accounts for 1/7 respectively, but makes up 3/7 on Wednesday. As a rule, the brokers publish tables in which they show the distribution of the bank interest on the days of the week. Remember that the bank interest is counted everyday! It is necessary to know that countries can adjust their interest rates at times to control the economic situation in a country. That is why it is necessary to follow global economic news, in order to react to the changes caused by the issue of the economic indices.