Chapter 12. Bank interest

At this point we have already found out that margin trading involves the use of borrowed capital – a trader borrows money to perform operations on Forex from his Internet broker. To understand the material of this chapter, we will need to study the principle of money circulation in the state. Imagine that a new state has been formed. There is able-bodied population, but there is no money in the state – what to do? The central bank of our virtual state commissions the Mint to print a series of banknotes of the established pattern. Suppose the banknotes are printed, but now how to distribute them among the population? A number of commercial banks appear in the state, which borrow from the Central Bank (make a loan). Credit, as we know, is not given for nothing, it must be paid for with interest. This is the key moment of formation of the monetary policy of the state. The central bank sets the interest rate at which it credits commercial banks. In different countries, this rate is called differently. In Russia it is called the refinancing rate (interest rate). In foreign literature it may be called interest rate, base rate, key bank rate, etc. Let’s return to our virtual state – now commercial banks have money, and they, in turn, begin to issue loans to organizations at a higher interest rate than the refinancing rate. Thus, commercial banks earn profit on the difference in loan rates. Organizations, on the other hand, set up their business, hire employees and pay their salaries. As a result of business processes in organizations, goods are created (or services are rendered). Organizations make profits and return the borrowed funds and interest to commercial banks. Commercial banks, in turn, pay back the loans to the Central Bank. As a result, money is spread around the state. Of course, this is a very simplified scheme, but understanding it is very important for learning about leveraged forex trading.

The interest rate in the government is one of the main levers to regulate the rate of inflation. Inflation is the growth of the amount of cash in circulation. In other words, there are more banknotes in circulation and more can be bought with them. In such a situation, organizations try to increase the prices of goods and services, as a result, money depreciates. To slow down the growth of inflation it is necessary to reduce the amount of cash in circulation. For this purpose, the government increases the interest rate. The meaning of increasing the interest rate to reduce the rate of inflation, at first glance, is not obvious, and to understand it is necessary to know the basis for the formation of money in the state. The higher the interest rate, the more commercial banks are forced to raise the rate on loans to organizations. Consequently, organizations borrow less, production is curtailed, wages are paid in smaller amounts, and, consequently, the amount of money in circulation decreases. As a side effect of this “intervention”, due to decreased production, unemployment rises in the state. From this example we can see that all processes in the state are interconnected, and it is often necessary to sacrifice one for the sake of another.

What is the point of all this for an Internet trader? Let’s consider an example, when we are going to buy US dollars for Japanese Yen at the USD/JPY quote. We have opened an account with an Internet broker for 1,000 USD. We have already said that the principle of margin trading allows us to buy dollars for Yen even if we don’t have Yen. But it is important to realize that Yen is not taken out of thin air – we borrow these Yen from the Internet broker! We use them to buy dollars (the Internet broker buys them on our behalf). And one more very important point – the purchased dollars remain with the Internet broker, we do not dispose of them. The only thing we can do with them is to sell them back for Yen, i.e. to close the position with profit or loss. So the purchased dollars remain with the Internet broker. In other words, we lend them to the Internet broker.

Please note that if we had opened a short position on the US dollar (selling US dollars for Japanese Yen), we would have lost 21 US dollars on the interest rate differential instead of making money. Whether you make or lose on the interest rate differential depends on the currency traded and the type of open position (long or short). The amount paid on the interest rate is called the bank interest. In margin trading, bank interest is always earned on the currency that is bought and is always paid on the currency that is bought for.

As we have just seen, it is possible to earn profit on Forex not only on changes in exchange rates, but also on the difference in interest rates of the countries of the world. The type of forex trading that involves earning on the difference in interest rates is called carry trading. Not all Internet brokers pay bank interest – there are some that only earn on the interest rate, but never pay it. Some Internet brokers may have current interest rates that differ from those set by the Central Banks of the respective countries of the world, and may also change over time. Therefore, consult with your Internet broker about paying bank interest on interest rates before you open a real account with him! When opening a position you should clearly understand the components of your income and your expenses, so that you do not open a position that is known to be unprofitable or close it with losses. It is important to realize that bank interest can be both a component of your profit and a component of your expenses. In the latter case, it is necessary to close the position so as not only to cover the spread, but also to cover the expenses on the bank interest.

The concept of bank interest and interest rates can be confusing to the novice Internet trader, so if you don’t want to get familiar with these concepts at the beginning, just don’t leave your positions open overnight. Use the day trading strategy exclusively. If a position is opened and closed on the same day, the bank interest on it is not calculated. Trading strategies will be discussed in detail in the Forex University section.

We have already mentioned that there is no active trading on Forex during weekends and holidays. Therefore, the bank interest can be calculated unevenly during the week. That is, it is not calculated on weekends, and the corresponding weekly share of bank interest is distributed on weekdays. Taking into account that there are 7 days in a week, we can have a situation when Monday, Tuesday, Thursday and Friday account for 1/7 of the weekly banking interest, and Wednesday accounts for 3/7. As a rule, Internet brokers publish a table in which they indicate the distribution of bank interest by days of the week. We would like to emphasize once again that the bank interest is calculated on a daily basis!

The table below shows the interest rates of the countries of the world, effective as of March 2008, in decreasing order of the share of forex trading in the corresponding currency. The table also contains the names of the Central Banks of the world countries and links to their Internet pages.

	USD	United States	3.0%	Federal Reserve Bank
	EUR	European Union	4.0%	European Central Bank
	JPY	Japan	0.5%	Bank of Japan
	GBP	United Kingdom	5.25%	Bank of England
	CHF	Switzerland	2.75%	Swiss National Bank
	AUD	Australia	7.25%	Reserve Bank of Australia
	CAD	Canada	3.5%	Bank of Canada
	SEK	Sweden	4.25%	Sveriges Riksbank
	HKD	Hong Kong	4.5%	Hong Kong Monetary Authority
	NOK	Norway	5.25%	Bank of Norway
	NZD	New Zealand	8.25%	Reserve Bank of New Zealand
	MXN	Mexico	7.25%	Bank of Mexico
	SGD	Singapore	~1.0%	Monetary Authority of Singapore
	KRW	South Korea	5.0%	Bank of Korea
	ZAR	South Africa	10.0%	South African Reserve Bank
	DKK	Denmark	4.25%	Danmarks Nationalbank
	RUB	Russia	10.25%	Bank of Russia

As can be seen from the table, Japan has the lowest interest rate (0.5%), which makes the Japanese Yen (JPY) very attractive for carry trading on Forex. It should be noted that, according to the monetary policy of Singapore, the interest rate on the Singapore dollar (SGD) is not fixed by the Central Bank, but is determined by trading on the international currency market, i.e. it is constantly changing. You should also be aware that from time to time countries increase or decrease the value of interest rate to adjust the economic situation in the country. Therefore, you should follow the economic news in the world in order to react in time to the changes caused by the release of economic indicators (we will talk about fundamental analysis in the Forex School section).