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Chapter 12: Banking Interest
By now, we have established that margin trading involves the use of borrowed capital, where traders borrow funds from their internet broker to execute Forex transactions. To understand the material in this chapter, we need to examine the principle of money circulation within a country.
Imagine a newly formed country with a working population but no money yet. What should be done? The central bank of our virtual country instructs the Mint House to print a series of banknotes according to a specified pattern. Suppose the banknotes are printed, but how should they be distributed among the population?
In the country, a number of commercial banks emerge, which borrow from the central bank (obtaining credit). As we know, credit is not given for free; it comes with interest payments. This is a key aspect of a country's monetary policy. The central bank sets an interest rate at which it lends to commercial banks. This interest rate is called different names in different countries. In Russia, it is referred to as the refinancing rate (interest rate). In foreign literature, it may be called the interest rate, base rate, key bank rate, and so on.
Let's return to our virtual country. Now, commercial banks have money, and they, in turn, start lending to organizations at an interest rate higher than the refinancing rate. This way, commercial banks earn profit from the difference in interest rates on loans. Organizations, on the other hand, establish businesses, hire employees, and pay them salaries. As a result of business processes within these organizations, goods are produced or services are rendered. The organizations generate profits and repay the borrowed funds and interest to the commercial banks. The commercial banks, in turn, repay their loans to the central bank. As a result, money circulates throughout the country.
Of course, this is a highly simplified scheme, but understanding it is crucial for studying Forex trading using borrowed capital.
The interest rate in a country is one of the key tools for regulating inflation rates. Inflation refers to the increase in the quantity of cash in circulation. In other words, there is more money in circulation, and with that money, one can purchase more. In such a situation, organizations try to raise prices for goods and services, resulting in the devaluation of money. To slow down inflation, the quantity of cash in circulation needs to be reduced. To achieve this, the government increases the interest rate.
The logic behind raising the interest rate to reduce inflation rates may not be immediately apparent, and understanding it requires knowledge of the fundamentals of money creation within a country. The higher the interest rate, the more commercial banks are forced to raise their lending rates to organizations. Consequently, organizations borrow less, production contracts, wages are paid in smaller amounts, and as a result, the quantity of money in circulation decreases. As a side effect of such intervention, due to the reduction in production, unemployment levels increase in the country.
This example demonstrates that all processes within a country are interconnected, and often one aspect has to be sacrificed for the sake of another.
What is the meaning of all this for an internet trader? Let's consider an example where we are planning to buy US dollars with Japanese yen using the USD/JPY exchange rate. We have opened an account with an internet broker with $1,000. As we discussed before, margin trading allows us to buy dollars with yen even if we don't have yen. But it's important to understand that yen doesn't come out of thin air - we borrow those yen from the internet broker! We use them to buy dollars (the internet broker buys them on our behalf). And here's another crucial point - the purchased dollars remain with the internet broker, we don't have control over them. The only thing we can do is sell them back for yen, i.e., close the position with profit or loss. So, the purchased dollars stay with the internet broker. In other words, we lend them to the internet broker.
We have already learned that if we borrow funds (take a loan), we have to pay interest at the corresponding interest rate. Since all Forex transactions take place at the interbank level, the same interest rate set by the Central Bank is used. Moreover, if we borrow US dollars, we pay interest at the interest rate set by the US Central Bank (Federal Reserve Bank). If we borrow Japanese yen, we pay interest at the interest rate set by the Bank of Japan. Different countries have different interest rates, and we will discuss this further.
The interest rate is expressed as an annual percentage (%). In Japan, at the time of writing this chapter, it is set at 0.5%, while in the United States, it is 3.0%. This means that for the Japanese yen we borrowed from the internet broker, we pay an annual interest rate of 0.5% of the loan amount. On the other hand, the internet broker pays us an annual interest rate of 3.0% for the US dollars we borrowed from them. It's important to note that this principle applies only if our long open position on the USD/JPY currency pair is not closed for several days. In other words, interest is calculated daily on open positions. If we close the position on the same day we opened it, interest rates are not used in the calculations.
Let's assume that our position was open for a month, and at the end of the month, we decided to close it. For simplicity, let's assume that the buying rate is equal to the selling rate, meaning that the USD/JPY exchange rate remained almost unchanged over the month. We didn't earn anything from the exchange rate difference. But what about the loans? We have to repay the internet broker 0.5% annual interest for one month, which is approximately 0.5% / 12 = 0.04% of the borrowed amount. We have to repay this amount in yen, but all calculations are converted into the currency of our account, in this case, US dollars, at the selling rate of the USD/JPY currency pair. The internet broker has to pay us 3.0% annual interest for one month, which is 3.0% / 12 = 0.25% of the borrowed amount in dollars. It\s important to understand that the borrowed amount we have to repay in yen and the amount they have to pay us in dollars are equivalent to the size of the open position, i.e., the size of one lot, mini-lot, or micro-lot, depending on the lot size we use. Let's assume the position was opened with one mini-lot (which is equivalent to $10,000). In our example, we would earn 0.25% - 0.04% = 0.21% on the interest rate difference, which is approximately 10,000 * 0.0021 = $21.
It should be noted that if we had opened a short position on the US dollar (selling US dollars for Japanese yen), we wouldn't have earned but instead lost $21 on the interest rate difference. Whether you earn or lose on the interest rate difference depends on the traded currency and the type of open position (long or short). The amount paid according to the interest rate is called bank interest. In margin trading, bank interest is always earned on the currency being bought and always paid in the currency being sold.
As we have just seen, profit in Forex can be earned not only from currency exchange rate fluctuations but also from the interest rate differentials between countries. The trading method on Forex that involves earning from interest rate differentials is called carry trading. Not all internet brokers pay bank interest; some brokers only earn from the interest rate differentials without making any payments. The current interest rates at some internet brokers may differ from those set by the central banks of the respective countries and may also change over time. Therefore, it is important to consult with your internet broker regarding the payment of bank interest based on the interest rates before opening a real account with them. When opening a position, you should have a clear understanding of your income and expenses, in order to avoid knowingly opening a losing position or closing it with losses. It is important to understand that bank interest can be a component of your profit or expenses. In the latter case, it is necessary to close the position in a way that not only covers the spread but also covers the expenses related to the bank interest.
The concepts of bank interest and interest rates can confuse a novice internet trader. If you don't want to deal with these concepts at the initial stage, simply avoid leaving your positions open overnight. Stick to day trading strategies exclusively. If a position is opened and closed within the same day, bank interest is not calculated. Detailed information about trading strategies will be provided in the Forex University section.
As we mentioned before, active trading is not conducted on weekends and holidays in the Forex market. Therefore, bank interest may be calculated unevenly throughout the week. It means that no interest is calculated on weekends, and the corresponding weekly portion of bank interest is distributed over weekdays. Considering that there are 7 days in a week, we can have a situation where Monday, Tuesday, Thursday, and Friday each account for 1/7th of the weekly bank interest, while Wednesday accounts for 3/7th. Usually, internet brokers publish a table indicating the distribution of bank interest by day of the week. It is important to note that bank interest is calculated on a daily basis.
Below is a table of interest rates in various countries as of March 2008, listed in descending order of their respective currency's trading share in the Forex market. The table also includes the names of the central banks of these countries and links to their respective websites.
| National flag | Currency code | English name of the currency | Russian name of the currency | Interest rate | Central bank |
 |
USD | United States | Соединенные Штаты Америки | 3.0% | Federal Reserve Bank |
 |
EUR | European Union | Евросоюз | 4.0% | European Central Bank |
 |
JPY | Japan | Япония | 0.5% | Bank of Japan |
 |
GBP | United Kingdom | Великобритания | 5.25% | Bank of England |
 |
CHF | Switzerland | Швейцария | 2.75% | Swiss National Bank |
 |
AUD | Australia | Австралия | 7.25% | Reserve Bank of Australia |
 |
CAD | Canada | Канада | 3.5% | Bank of Canada |
 |
SEK | Sweden | Швеция | 4.25% | Sveriges Riksbank |
 |
HKD | Hong Kong | Гонг-Конг | 4.5% | Hong Kong Monetary Authority |
 |
NOK | Norway | Норвегия | 5.25% | Bank of Norway |
 |
NZD | New Zealand | Новая Зеландия | 8.25% | Reserve Bank of New Zealand |
 |
MXN | Mexico | Мексика | 7.25% | Bank of Mexico |
 |
SGD | Singapore | Сингапур | ~1.0% | Monetary Authority of Singapore |
 |
KRW | South Korea | Южная Корея | 5.0% | Bank of Korea |
 |
ZAR | South Africa | Южная Африка | 10.0% | South African Reserve Bank |
 |
DKK | Denmark | Дания | 4.25% | Danmarks Nationalbank |
 |
RUB | Russia | Россия | 10.25% | Bank of Russia |
As seen in the table, Japan has the lowest interest rate (0.5%), making the Japanese Yen (JPY) highly attractive for carry trading in the Forex market. It is worth noting that according to Singapore's monetary policy, the interest rate for the Singapore Dollar (SGD) is not fixed by the central bank but determined by trading on the international currency market, meaning it fluctuates constantly. Additionally, it is important to know that countries occasionally increase or decrease their interest rates to adjust the economic conditions within their respective countries. Therefore, it is necessary to stay informed about global economic news to timely react to changes triggered by economic indicators (fundamental analysis will be covered in the Forex School section).