Compound interest can really work for you when trading forex and can help you turn a decent trade into a great trade if it can be held over time. Conversely, it can cost you plenty of money if you take overnight positions in which you pay away compound interest.
An important thing to remember about compound interest is that it’s positive or negative effects get magnified substantially when you trade in currency pairs that involve a substantial interest rate differential between the component currencies.
Furthermore, compound interest has an especially powerful effect on the carry trade strategy often used by hedge funds and other currency speculators. Learn more about the carry trade here.
Using Rollovers to Earn Compound Interest
Some currency pairs have a substantial interest rate differential, and over a longer-term period of a year or more, this differential can give a decent return to a carry trader all by itself.
Nevertheless, performing monthly or daily forex rollovers at competitive spreads will usually give a carry trader the opportunity to compound their interest further, as well as accrue the simple interest rate differential. Read more on forex rollover considerations.
How Compounding Affects Returns
The frequency of their rollover period, whether daily, monthly or at another frequency will determine how much of a compounding effect they can expect.
In general, the more often you compound your interest at competitive rollover spreads with a carry trade, the greater a return you will see by the time you close out your carry trade. This holds provided that the interest rate differential remains constant during the compounding period.
Note that a narrowing of the interest rate differential for the currency pair can negatively affect your carry trade, while a widening of the interest rate differential can benefit your carry trade’s overall return if such shifts occur between compounding periods.
Compound Interest Example
The following example shows the effect of compounding interest with different frequencies over the same overall forex carry trade period.
For example, if a carry trader is considering trading a currency pair with an annualized interest rate differential of 4.4%, like AUD/JPY perhaps, this can result in a compounded annual return of 4.4898% if the interest is compounded monthly or an annual return of 4.4980% if the interest is compounded daily.
The following table shows how the compounded balance grows on a monthly basis for daily, monthly and annual compounding options for a A$1,000,000 position at a annual interest rate differential of 4.4%. The interest rate differential remains constant throughout the compounding period, although this might change in practice.
Monthly Compounded Balance
Month Daily Monthly Annually
1 1,003,673 1,003,667 1,000,000
2 1,007,360 1,007,347 1,000,000
3 1,011,060 1,011,040 1,000,000
4 1,014,774 1,014,748 1,000,000
5 1,018,501 1,018,468 1,000,000
6 1,022,242 1,022,203 1,000,000
7 1,025,997 1,025,951 1,000,000
8 1,029,766 1,029,713 1,000,000
9 1,033,548 1,033,488 1,000,000
10 1,037,345 1,037,278 1,000,000
11 1,041,155 1,041,081 1,000,000
12 1,044,980 1,044,898 1,044,000
A$ Return 44,980 44,898 44,000
As the table shows, the trader’s annual return using daily compounding would be A$44,980, using monthly compounding would be A$44,898, while using simple annual compounding would be A$44,000.
This return calculation assumes no change in the interest rate differential, although an increase in the interest rate differential would increase carry returns on subsequent months that the position is held.