In forex trading, when you keep a position open through the end of the trading day, you will either be paid or charged interest on that position, depending on the underlying interest rates of the two currencies in the pair. As the currency markets involve a simultaneous buying or selling of one currency to another, the guiding interest rate difference for the currency pair you are trading determines the outcome. For overnight positions, you are either levied a positive swap (the swap rate is added to your trade) or a negative swap (the swap rate is subtracted from your trade).
Swap rate is defined as the overnight rollover interest for open positions. Swap rates or rollover rates are typically charged on an overnight basis and a triple rollover or triple swap rate is applied every Wednesday. In theory, when you buy a currency with higher interest rate and sell a currency with lower interest rate, you are charged a positive swap. Likewise, when you buy a currency with lower interest rate and sell a currency with higher interest rate, you are charged a negative swap.
Currency swaps are an essential financial instrument utilized by banks, multinational corporations and institutional investors. Although these type of swaps function in a similar fashion to interest rate swaps and equity swaps, there are some major fundamental qualities that make currency swaps unique and thus slightly more complicated. A currency swap involves two parties that exchange a notional principal with one another in order to gain exposure to a desired currency. Following the initial notional exchange, periodic cash flows are exchanged in the appropriate currency.
When you make a forex trade, you are effectively borrowing one currency to exchange for another. You must therefore logically pay interest on the currency you are borrowing, while receiving in return interest on the currency you are holding in return. There is usually an interest rate differential between the two currencies, which means you should either be receiving or paying some extra fee each night representing the differential, and of course the exchange rate is a factor as currencies rarely trade at 1 to 1. The only time there would be nothing to pay or receive would be if the exchange rates were exactly equal at the rollover point, and there was no interest rate differential.
Swaps can be an additional way to earn interest on open positions, especially if a positive swap is added to your position. This way, you can at the very least manage to cover any commissions or spreads that your broker might charge you and thus virtually trade for free. However, most traders are highly leveraged, which means that they are borrowing the vast majority of the currency they are trading. Traders tend to forget that one of the negative consequences of leverage is to push up the overnight swap charges, as they must pay interest on all the borrowed money, and not just the margin that they are putting up on the particular trade. Of course, this is a legitimate element of the charge.
