Who or what pays (receives) interest on higher (lower) interest rate currencies?

[pipeguy]

Never even ventured into Forex, but I love the idea. So I would think an easy way to make money would be to pick a currency that is strong over long periods, pick one that is weak, buy the former against the latter. Say the USD versus Mexican Peso. Over any meaningful period over the last say 30 years I've only see the Peso depreciate versus the dollar. So, I would go long dollar and short the peso.

But I understand its not that easy. Because if the interest rate in Mexico (or some interest rate, not sure which one - the central bank one?) is higher than the U.S., if you are long dollar/short Peso you will have to pay someone interest? I assume the counterparty? But why? And how does all that work?

Thanks!

Exotic currency pairs tend to behave under the law of carry trading (currency with higher rate attracts capital if liquidity is high, country risk and volatility are low). Also exchange rates are often considered as stochastic process with Markov Property, i.e. past returns has no influence on present so it is illusion to assume that one currency is stronger than another based on past price action.

 

[Wheezooo]

Still confused. To unnecessarily complicate things...

Say I have 10oz of gold I don’t want anymore. I want to fund an account and buy currency B. Gold is $1500 an oz. I sell it for $15,000 (Dr/gld – cr/USD) put that into my account and use it to get long currency B trading 12:1 to the USD. (Dr/USD –Cr/B). Tonight news comes out. My trade sucked. Currency B goes to 14:1. I want out. I liquidate (Dr/B Cr/USD). Net liq of my account $12,857. I want back into gold. Gold still trading $1500. (Dr/USD – Cr/Gld) Now long 8.57oz gold. Fuck me!

Say I have 10oz of gold I don’t want anymore. I want currency B. Gold is $1500 and oz. I sell it for $15,000 (Dr/gld – cr/USD) take that to a currency exchange and use it to buy 180,000 units of currency B trading 12:1 to the USD. (Dr/USD –Cr/B). Tonight news comes out. Currency B goes to 14:1. I want out. I want my gold back. I find someone willing to sell me gold directly in currency B, now trading (21,000 B per oz.) (Dr/180000B – Cr GLD) - Now long 8.57oz gold. Fuck me!

So Dr/Cr are all the same and so is the p+l

You edited out the apples and oranges, which isn't really fair since they are both perishables. Which is why you get crazy ass backwardations, contangos, and seasonality in those products. But if they weren't, my answer would be, Yes. You just perfectly defined EXACTLY how everything looks to me. Just A vs B vs C (add in next 6,000 letter sequences). Once upon a time, I gladly woulda flipped ya' a warehouse of shit for a tanker of shinola if you mispriced the forwards. Don't even know what shinola is, and wouldn't have cared less.

 

[Wheezooo]

Exotic currency pairs tend to behave under the law of carry trading (currency with higher rate attracts capital if liquidity is high, country risk and volatility are low). Also exchange rates are often considered as stochastic process with Markov Property, i.e. past returns has no influence on present so it is illusion to assume that one currency is stronger than another based on past price action.

Nope. I'll come back and address this in about 6-12 months.

 

[Sig]

To the OP, the carry you pay based on the interest rate differential in forex is determined by the no arbitrage rule. Basically, if on currency has a higher interest rate than another you could borrow in the low interest currency, convert, and lend in the higher interest rate currency while buying a forward or future to lock in your currency exposure thus earning a risk free profit. Obviously everyone with half a brain realizes this, so the futures rate for a currency is exactly the amount of this risk free profit, thus eliminating it. Same thing for the daily roll interest, it exactly matches the amount you could otherwise get in an arbitrage situation. If you're using a "broker" they set the roll rate such that they make money off it no matter which side of the transaction you're on, i.e. lower credit rate then the official credit rate and higher debit interest rate than the official rate, but they're just setting it based on the currency interest rate differential. So bottom line is there's no free lunch to be had based on interest rate differentials between currency. And as a useful heuristic going forward, any risk free profit that anyone with moderate intelligence and some exposure to finance could figure out can be safely assumed to be arb'd out of existence in microseconds, so while it's certainly a great idea to ask questions about anything that appears to offer risk free profit, any time I see it I assume I'm missing something not that I've found a massive holy grail that someone all the other smart people in the market somehow missed.