Example
On 26th October, a Thursday, Bank A buys $1,000,000 from Bank B as a spot transaction at a rate of $/DM 1.7500. The value date is Monday, 30th October, two business days later. On 30th October, Bank B delivers $1,000,000 to Bank A and Bank A delivers DM1,750,000 to Bank B.

Rollovers

In the majority of currencies, spot dealing for the current day’s spot value date ends at 22.00 London time. Any position still held at this time must be rolled forward to the next spot value date, or a date after that, if the delivery of currency is to be avoided. Currency speculators, including private investors, usually never wish to take or make delivery of currencies other than their ‘home’ currency. They therefore leave a standing instruction to roll over any spot positions still open at the close of day trade business to the next prevailing spot value date. This daily rollover is known as a tom. next (short for ‘tomorrow and the next day’). It is a common procedure in the foreign exchange market.

IG Index will always roll any spot positions open at the close of day trade business (normally at 22.00), unless you have confirmed to us that you want to run the position to delivery. So there is no danger that you may accidentally have to take and make delivery.

The rollover mechanism is quite straightforward. The effect is to close your spot position and open a new position of the same size for the next spot value date. You then have until 22.00 the following trading day to close your new position. If you do not do so, the new position is in turn rolled to the next spot value date, and so on until you do decide to close the position.

Example
It is Monday, 12th February. You buy $500,000 against the mark at 1.7500 as a spot deal. The value date is Wednesday, 14th February.

1. When a position is rolled, the spot position is closed. Any profit or loss on the spot position is realized on the value date (normally two days later). In this case, your position for value 14th February has been closed at a profit of DM 1,000. You only had to sell DM875,000 for your dollars when you opened the transaction and you bought DM876,000 when you closed it.

You have opened a new position for value 15th February.

2. When a position is rolled, the spot position is closed at one rate and the new position for the next value date is normally opened at a slightly different rate.

In this case the spot position was closed at $/DM 1.7520 and the position for the new value date was opened at $/DM 1.7519, a discount of one pip. The difference reflects the difference between overnight dollar and Deutschemark interest rates. In this case Deutschemark overnight interest rates are lower than dollar rates, so the $/DM rate for the new value date is at a discount to the spot rate (for a explanation of why this is so, see the next section ‘Forward Dealing’). Your position is long of dollars and short of Deutschemarks, so you make this one pip when you roll the position. You are able to buy your dollars for the new value date more cheaply than you sold your spot dollars.

If you had the opposite position, short of dollars and long of Deutschemarks, the opposite would apply; you would lose this differential when you rolled your position.

It is easy to work out whether you will gain or lose on a rollover if you remember the following:

If you are long of the first named currency:

You gain on a rollover if the currency rate for the next value date is at a discount to spot. You lose on a rollover if the currency rate for the next value date is at a premium to spot.

If you are short of the first named currency:

You lose on a rollover if the currency rate for the next value date is at a discount to spot. You gain on a rollover if the currency rate for the next value date is at a premium to spot.

The currency rate for the next value date will be at a premium to spot if overnight interest rates in the first named currency are lower than overnight interest rates in the second named currency.

The currency rate for the next value date will be at a discount to spot if overnight interest rates in the first named currency are higher than overnight interest rates in the second named currency.

So the market rewards you for rolling a long position in the higher interest currency and penalizes you for rolling a long position in the lower interest rate currency.

Forward dealing

Not all foreign exchange transactions are spot. In the foreign exchange market it is possible to deal for any value date up to one year ahead. Deals of this type are called forward transactions.

A forward currency rate will nearly always trade at either a premium or a discount to the corresponding spot rate. This difference in price does not reflect an expectation that the spot rate will rise or fall in the future; it reflects the difference in interest rates applying in the two currencies over the relevant period.

The currency with the higher interest rate will always be less valuable for forward delivery than for spot delivery. If this were not so, and the spot and forward exchange rates were the same, it would be possible to make a guaranteed profit in the following way:

You would borrow the lower interest rate currency and use it to buy the higher rate currency for spot. At the same time, you would sell the higher rate currency for the lower rate currency for a forward date at the same rate. As the two transactions would be at the same exchange rate you would make no profit or loss on them, but you would earn more interest in the higher rate currency than you would be paying in the lower rate currency. In other words you would have a guaranteed profit with no risk. Naturally the markets make sure that does not happen.

Forward rates will always move to a level at which the interest rate differential is taken fully into account. There is a simple way to tell whether the forward rate for a particular currency pair is at a premium or a discount to the spot rate:

If interest rates in the second-named currency are higher than in the first named currency over the relevant period, then the forward rate will be at a premium to the spot rate.

If interest rates in the second-named currency are lower than in the first named currency over the relevant period, then the forward rate will be at a discount to the spot rate.

When a currency is traded for a forward date, the spot rate is often agreed first and the premium or discount for the forward date, sometimes called the swap, is agreed immediately afterwards. Less commonly, the forward rate is quoted outright. Outright forward rates and swap rates are both quoted as two-way prices.

Example

A dealer might quote spot $/DM as 1.7500 - 1.7505 and the spot to three months forward swap for $/DM as:

40 - 37 (sometimes written as 40/37)

This means that the dealer will buy dollars three months forward at 40 pips below his spot bid and sell dollars three months forward at 37 pips below his spot offer.

So his forward quote is:

When forward swap rates are quoted or written, the convention is as follows:

If the first (left hand) number is higher than the second (right hand) number (e.g. 40-37), then the forward rate is at a discount to spot.

.If the first (left hand) number is lower than the second (right hand) number (e.g. 25-28), then the forward rate is at a premium to spot.

Spot or forward?

When you take a speculative position in a currency you have to decide whether to trade spot or forward. In practice, most speculators trade spot unless they think it very likely that they will want to keep the position open for several weeks. For shorter-term trading, taking a spot position and rolling it over as required has clear advantages:

1. The dealing spread will nearly always be wider on a forward than on the corresponding spot trade. Provided you do not intend to hold a position for more than 20 days, it is normally cheaper in terms of dealing spread to trade spot and roll over day by day.

2. In the foreign exchange market, locked-in profits are not payable until the value date. When you trade spot, the value date is normally two business days later; on a forward position you might have to wait months.

3. Forward premiums and discounts do not remain constant. If you have a forward position your profit or loss is affected by movements in the forward swap rate as well as the spot price.