Most countries have a central bank which makes monetary policy decisions. These central banks usually have a “benchmark” interest rate. This benchmark interest rate serves as a guide for interest rates that the central bank as well as other commercial banks lend to each other in order to cover short-term operational needs. These interest rate decisions can also have a significant affect in the forex markets.
Rate of Return
The basic reason why interest rates are so important in currency markets is that changes in interest rate policies affect the rate of return of investing in a particular currency. The higher the interest rate the more return traders will accrue which will translate into higher profits. An increase in interest rates from a central bank will generally result in appreciation of that currency.
The difference in interest rates between different currencies has given birth to a popular strategy among forex traders known as the “carry trade”. This strategy is simply purchasing a high interest rate currency and funding it with a currency with a lower interest rate, therefore earning the difference in interest rates. The longer the trader holds the position the more interest he or she will earn. The use of this strategy by traders also adds market significance to interest rate decisions.
Interest Rate Expectations
Not only are actual interest rate decisions deemed important by forex traders, the large amount of significance placed on interest rate policies has also given importance to market expectations of future interest rate movements. These expectations will play a significant role in forming market sentiment. Traders look to economic indicators as well as statement releases and press conferences from central bank officials in order to attempt to forecast the timing and size of upcoming interest rate increases or decreases.
On the other hand, nobody can truly predict what central banks will decide to do in regards to interest rate policies. Unexpected moves can cause high volatility in financial markets including the currency markets. This can produce opportunity for traders but it can also cause serious losses to one’s account. Therefore, it is best to have an effective risk management strategy when trading in forex. Failure to do so can potentially result in a trader losing all of one’s invested capital.
Le Bach Pham has been writing professionally after receiving his Bachelor’s of Art in English Literature from the University of California, San Diego in 2002. He now specializes in writing about legal, business and financial topics. Pham also earned a Paralegal Certificate from the University of San Diego and has experience working in the legal field. He also has experience in writing business plans for clients from various fields, including banking, finance, retail, education, beauty and various other sectors.