Tom-Next & Carry Trades Explained
This educational article covers forex funding (technical term Tom-Next), so that you know how this cost occurs and how it is possible to make a profit simply from keeping a position running over time. Please also make sure you have read “What is FX?”, especially if you are new to forex trading.
Tom-Next stands for tomorrow-next day. Traders who deal within the forex market will have come across this terminology. Tom-Next can be seen as a funding cost or a cost of carry, meaning that the trader wants to keep his/her position open rather than taking the physical delivery of the currency.
In the real world of buying or selling currencies you actually want to receive the currency. As a trader, on the other hand, you do not want to receive any physical goods and want to make a profit by engaging in currency trading.
In technical terms it’s the amount you will pay or receive depending on whether the calculated adjusting closing level is higher or lower compared with the currency involved. Brokers will normally add a small amount of interest on this calculation as well.
Most currencies will settle on a T+2 basis (one exception is USD/CAD which settles T+1), which means the transaction day plus two days; this is when you would receive your currency. The reason this is relevant, is that retail investors sometimes question why they pay for three days mid-week. If they are holding a position on Wednesday after the cut off time, their delivery date for currencies would actually fall on the weekend and therefore they are charged for three days. Just to be clear you still pay for seven days during one week but the forex weekend is just shifted and you only pay for one day for holding a position on Friday close.
It is possible that your broker charges you for three days on the Friday close, the problem occurs if your broker does not charge you during the same day as they get charged for hedging your position, making the cost for your broker and money you pay to them out of sync. That so called problem will be for your broker, not for you.
Let’s assume you are trading GBP/USD, currently (17 April), the Bank of England has its interest rate very low and the US Federal Reserve has higher interest rates. If you go long on the pair you need to pay or if you go short you will actually receive money.
Carry Trades Explained
Carry trades are not a new phenomenon and are not a money printing certainty but they are a handy tool that should definitely not be ignored. In a nutshell a Carry Trade is when you are able to borrow money at a cheaper rate, than the return of an investment.
For example, Australia currently has relatively high interest rates and Japan has low rates. Let’s assume that I go to a Japanese bank and borrow money at a rate of 1%, and then convert my Japanese Yen to Australian Dollars. I go to an Australian bank which offers me a 4% return for leaving my money with them. Simply put 4% -1% = 3% return, essentially for doing absolutely nothing.
Now the main thing we need to watch out for is the exchange rate AUD/JPY. If the exchange rate stays the same/unchanged it’s fine, because we will be receiving money overall (the above mentioned 3%).
If the exchange rate goes in my favour, the Australian dollar appreciates and we will be making money in two ways. We will be benefiting from the 3% and also the change in interest rate. On the other hand we do have a problem if the Japanese Yen appreciates, as my debt is in Yen and if I would want to liquidate my Australian bank account and change my money back into Yen, I would not have enough Yen to pay back my full loan.
As you and I now know this trick, so do others. Meaning if many people undertook the above trade and suddenly panicked, the result would be a so called snowballing effect. More people dump their AUD’s for JPY which will squeeze more people and so on.
When dealing with Tom-Next and Carry Trades it is worth remembering that extreme forex market conditions make this topic more relevant; meaning the larger the difference between the two currency interest rates, the more money you could earn or pay. If the two currency interest rates are similar, less importance can be placed upon Tom-Next. As always, when trading long-term, funding costs and individual earnings should be considered in the overall profit/loss of the trading position.
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