What is overnight interest?

Key points:

* Overnight interest is calculated based on the interest on the purchased currency minus the interest on the sold currency

Carry traders typically trade using interest rate differentials in different currencies

In this article, we will take a deep dive into the concept of overnight interest. First we will explain the concept of overnight interest, then we will give examples, and finally we will show how to profit from overnight interest. Because many successful traders consider overnight interest as an important part of their trading strategy.

Overnight interest, as the name suggests, is the daily interest that can be earned or paid based on the total number of positions held. Each currency has its own base rate, which is usually set by the country's central bank. You can check the latest interest rate for each currency through the DailyFX Central Bank News section.

As we mentioned in our article "How to Interpret Foreign Exchange Quotes", when you buy one currency, you are actually selling another currency. So, the currency you buy will help you earn interest, but the currency you sell (or borrow) needs to pay interest. Every day at 5am Beijing time, your account will automatically settle the net interest. But if you position squaring before 5am or place a position after 5am, you don't have to pay or earn any interest.

For example:

When you buy AUD/USD, you are actually buying AUD and selling USD. Assuming you buy a mini lot (i.e. 10,000 currency units) of AUD/USD, based on the 1.5% base rate currently set by the RBA, you will earn AUD $150 per year. Dividing AUD $150 by 365 days gives you a daily interest rate of AUD $0.41.

On the other hand, we sold about $8,000 (the AUD/USD exchange rate is about 0.8000 at the time of writing), so we would pay between $80 and $120 per year in interest, divided by 365 days, resulting in a daily interest rate of $0.22 to $0.33. For ease of calculation, we can convert the interest earned in AUD to USD, which is $0.33. Therefore, we would earn between $0 and $0.11 per day in interest.

Now you can log in to your trading account to confirm.

You may find that the interest we calculate does not match the actual interest we earn. This is because the interest rate we use to calculate the interest is the base rate provided by the central bank of various countries. But when it comes to the bank, the actual overnight loan and deposit interest rate will be slightly different from the base rate. So our calculation here is just to demonstrate and help readers understand the concept of overnight interest. The specific interest calculation has to be based on different bank standards.

Maybe you want to ask another question: Why do we earn less interest through overnight interest than we are deducted? For example, if we buy AUD/USD, we will earn $0.49 per day; but if we sell AUD/USD, we will have to pay $1.07 per day as interest. This is because just as the foreign exchange quotation provided by the bank has a trading spread, the overnight interest rate offered by the bank also has a slight difference. Usually, the interest paid by the bank to the trader will be a little lower than the base rate, but the interest paid by the trader to the bank will be higher than the base rate. The end result is that whether we buy or sell, we will lose some interest spread to the bank. But this does not affect the huge impact of overnight interest on foreign exchange trading strategies. There are even some traders who take advantage of the different base rates andforeign exchange marketThe high leverage to gain profits, this kind of trade is collectively referred to as the "carry trade".

carry trade

For example, if we sold a mini lot of GBP/AUD, we would earn $0.81 per day in interest. This may not sound like much, but over time it adds up to $295.65 over the course of a year. And that's just interest, not including the profits that exchange rate fluctuations might bring us. Also, if you consider that we may only need to provide a margin of around 2% to make this transaction, then the interest rate return of $295.65 becomes quite impressive. This trading method of holding a pair of currencies for a long time to earn its interest rate difference is known as the "carry trade" and has been one of the most popular trading methods in recent years.

But we must remember that carry trades are also risky. Because interest rates themselves fluctuate every day, this may bring us profits or losses. And fluctuations in interest rates can affect our total capital, which in turn affects our interest rates. So, if you want to become a carry trader, you need to have a certain understanding and awareness of interest rate fluctuations in the foreign exchange market.

The last thing to note about overnight interest is that the interest calculation is slightly different every Thursday. Because the foreign exchange market usually has a 2-day cycle, this means that your trade is not really completed until 2 days after you open your position. So trades made after 5am on Thursday will be moved to the next trading day for calculation, which means that the transaction will be completed at 5am on Sunday. But banks are closed on Saturdays and Sundays, so generally trades made after 5am on Thursday will accumulate 3 days of interest and settle at 5am on Tuesday (weekends are not counted as interest). In addition, holidays will also affect the calculation and settlement of interest.