# Computing Swap Points

The difference between the forward rate and the spot rate for a particular currency pair when expressed in pips is typically known as the swap points.

These points are computed using an economic concept called Interest Rate Parity. This theory implies that the hedged returns received after investing funds in differing currencies should equate irrespective of what their interest rates are.

Using this theory, forward traders determine the forex swap points for any given delivery date mathematically by considering the net cost or benefit involved when lending a currency and borrowing another against it during the period of time encompassed by the spot value date and the forward delivery date.

## Computing Forward Prices and Swap Points

The fundamental equation used to compute forward rates when the U.S. dollar acts as base currency is:

Forward Price = Spot Price x (1 + Ir Foreign)/(1+Ir US)

Where the term "Ir Foreign" is the interest rate for the counter currency, and "Ir US" refers to the interest rate in the United States. Using that as the basis for computing the swap points, one then gets:

Swap Points = Forward Price - Spot Price

= Spot Price x( (1 + Ir Foreign)/(1+Ir US) - 1)

## Rollover Swap Example

Now consider a practical example to illustrate how the above swap points equation works in the case of computing the fair value for a rollover swap.

To do this, you would first need to determine what the prevailing short term Interbank deposit rates are for each of the currencies involved in the pair you are trading. You could then use the above equation to compute the swap points for a currency pair in which the U.S. Dollar was the base currency.

Alternatively, you could also calculate the rollover by netting out the interest rates for each of the currencies involved. As an example, consider a tom/next rollover of a short AUD/USD position where you would roll the position from delivery on the following business day from today (known as Tomorrow or Tom for short) until the next business day forward from that.

The short term interest rate for the U.S. Dollar is only 0.25% and that is the currency which has been bought and therefore is held long, so you will gain that interest rate on the currency.

Furthermore, the short term interest rate for the Australian Dollar is 4.5% and that is the currency that had been sold and hence is held short. As a result, you will pay that interest rate on the currency.

This nets out to an annualized interest rate differential for the currency pair of 4.25%. Of course, you are not doing the rollover for a year, so you will need to adjust it for the time period covered by the underlying tom/next swap.

Therefore, the theoretical rollover fee on holding a short AUD/USD position overnight would cost the trader the annualized interest rate differential of 4.25% divided by 360, when assuming a one day tom/next rollover period and a 30/360 day count basis.

You would then multiply the resulting interest rate differential for the tom/next period by the notional amount of the transaction to get a currency quantity for the rollover fee. You can then convert this currency quantity into AUD/USD pips to get a fair value for the actual rollover fee since it is often charged by forex retail brokers in pips.

Conversely, the trader would receive a similar amount out to roll over a long position in AUD/USD. The amount received would generally be less since it would be adjusted downward by the forex broker's rollover bid/offer spread.

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Read our brief explanation of a currency swap.

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Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

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