Interest rate differential

Each currency has its own interest rates, set largely by its central bank. The gap between them, the interest rate differential, matters to forex traders in two ways.

1. It sets the swap

When you hold a position overnight, you are in effect holding one currency and owing the other. The broker credits or debits interest based on the differential, plus its own mark-up. This is the overnight swap or rollover charge. Being long the higher-yielding currency can earn a small credit; being short it usually costs.

2. It influences the exchange rate

Capital tends to move towards higher returns. When one country's rates rise relative to another's, or are expected to, its currency often strengthens. Traders watch changes in two-year government bond yields, which reflect expected policy rates, as much as the policy rates themselves.

Worked example

Illustratively, the US policy rate is 4.50% and Japan's is 0.50%: a differential of 400 basis points in the dollar's favour. A trader long USD/JPY may receive a positive swap each night, while a trader short USD/JPY pays one. If the Fed signals cuts and the BoJ signals hikes, the expected differential narrows, which tends to weigh on USD/JPY even if current rates have not changed.

Practical notes

• The differential is one influence among many. Risk sentiment can overwhelm it, especially during a carry trade unwind.
• Swap rates are set by the broker and vary between firms. Check them in the platform before holding positions for long.

See swap and overnight financing.