Effects of Continuous Interest Rate Payment
OANDA makes continuous interest rate payments second by second. This is in
contrast to other financial markets, where interest rate payments are made at
daily intervals with the shortest increment of one business day. To illustrate
the traditional convention is comparable to an electricity company that bills
on the basis of lights being used at 7 PM in the evening and charging for a
usage of electricity of 24 hours based on the usage at 7 PM only. If an electricity
company would actually do this, it would create an uproar.
So far, the public press and academic literature has failed to draw attention
to the fact that the convention of daily interest rate payments in financial
markets has a negative impact on exchange and interest rate stability. With
the growth of international capital flows and the increased speed at which financial
transactions are executed the negative impact has become a serious issue. Just
remember the exchange rate crisis in Turkey that started in November 2000 and
continued on in February and March 2001, or the Asian and Russian crisis in
1998. Intraday trading is an important source of market liquidity for the capital
movements of long term investors. The OANDA FX Trade platform has been designed
to support this type of trading opening the market to transactions of any size
starting at 1 USD and charging 0.02 percent spread (2 pips) in the common case,
with no commissions.
For exchange and interest rate stability, it is important that intraday trading
does not introduce unnecessary instability into the system. Unfortunately, the
convention of daily interest rate payments does exactly that. To give you an
indication of the importance of introducing continuous interest rate payments,
lets analyze the USD/JPY exchange rate.
If we assume that an intraday trader is able to assume a yearly Sharpe ratio
of 1, where the Sharpe ratio is a direct measure of reward-to-risk with the
following definition:
|
Sharpe ratio = (return - rfree) / (standard deviation
of return)
|
where:
return: is the average rate of return on investment for a given period
rfree: is the best available rate of return of a "risk-free" security
|
If for instance the yearly standard deviation of the trader's P&L is 10%,
and if we neglect his cost of capital, and set therefore the risk-free rate
of return to 0 (rfree = 0), his yearly return will
also need to be 10% for the Sharpe Ratio to be equal to 1.
If the trader does not have any overnight positions, his cost of carry is
zero.
On average, for each of the 250 business day in a year, the trader earns 4
basis points of interest: 10% / 250 = 4 (3.8 basis points if you assume
compounding of return), and has a daily standard deviation of 60 basis points:
10% / sqrt(250) = 60.
If the trader in question had to pay an average intraday carry of 2 basis
points (it is about 1.5 basis points a day in USD/JPY), his Sharpe ratio would
have to be 0.5 a year (assuming the standard deviation of his P&L remains
the same). Because every trader has the conviction that he can outwit the market,
he will definitely prefer a scheme with continuous interest rate payments, because
he can use the interest rate differential in his favor to earn additional income
on the interest rate carry.
With the introduction of continuous interest rate payments, the yield curve
will extend to a shortest increment of one second - today, the shortest term
interest rate is one day. In the same way, as central banks can influence the
daily interest rate, they will be able to intervene on the micro yield curve.
The ability to set intraday interest rates will give a central bank defending
its currency a powerful weapon. In fact intraday interest rates will play the
role of a 'tax' on intraday sales of the currency under attack.
Continuous interest rates can have similar effect on the Tobin
tax (the proposal, which we do not support, by Tobin, to tax all financial
transactions, such as FX deals, to curb speculation), but one that can be tuned
according to market conditions.
Paying intraday interest requires real-time gross settlement. It is incompatible
with deferred net settlement. If the idea of paying intraday interest catches
on, it will cause a major rethinking (or more likely a revolution) in money
markets/treasury operations, and also central bank operations. Central banks
would have to learn how to manage/set intraday rates without causing interbank
settlement systems to hang for lack of liquidity.
OANDA's FXTrade pays continuos interest
rates on currency trading accounts!
See OANDA's Interest Payment
Calculation for details on how interest is calculated and paid
on FXTrade accounts.
