Interest Rates in Forex

JacqStone · Newbie Joined: Jul 27, 2011 Posts: 134

Interest rates are the important role in the foreign exchange market because it has the capability to move the exchange rates of currencies. Therefore, the central banks are the most influential player in this case as the central banks set the interest rates. Different in interest rates have an effect on the relative worth of currencies in relation to one another. Overall, the higher interest rates generate a stronger currency and vice versa.

Forex market experience volatility when central banks change the interest rates. An accurate speculation of central banks' actions is important for most of the traders. A higher interest rate will encourage traders to invest in that currency and cause the demand for that currency to rise. As the result of increasing demand, foreign investments are drawn to the currency and thus causing the currency to increase in value. In opposition, fall in interest rates will discourage investors and the currency will depreciate due to weaker demand.

For an example, a US investor that wants to deposit a saving account of 1000 dollars with domestic or foreign banks. The US, Japan and Switzerland bank's interest rate are 4.5%, 0.5% and 5.5% respectively. Among all the options, deposit the money in the Switzerland bank is the best option that generates highest return for that investor. The high interest rate in Switzerland bank had attracted foreign investors and this will take effects into the growth of currency value.

Since Forex is the simultaneous transaction of two currencies, then the market must focus on two respective interest rates, which is the base currency interest rate and the quote currency interest rate. This will generate an interest rate differential and this is a basic factor in the Forex markets. Traders will react when the interest rate differential changes, not the interest rates themselves.

Traders approaches the interest rates based on trading expectation and facts. When there is rumor about changes in interest rate differential, traders will react before the fact. However, the quieter of the markets is before a news release will normally signify a huge movement in the market. Besides, the market expectations and actual new release will cause a potential breakout opportunity. The news that comes out as the market expected usually do not cause a strong market reaction. On the other hand, a sudden unexpected change in interest rates is then possibly to trigger a sharp currency move.

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