Forex trading is one of the most volatile financial markets. The rates of exchange are ever on the move as influenced by several factors. Part of these factors is the interest rates imposed by financial institutions especially the central bank. The central bank interest rates used to issue short-term loans to commercial banks will have a great impact on Forex trading returns in the market. If you don’t understand how this works, it may appear strange for you.
The interest rate of a currency is a key factor in determining the flow of Forex trading. Gaining interest in money is valued as a good practice hence the fluctuation in interest rates in the market. Many money market investors target gains from the use of money through investment instruments such as bonds and so on.
Insight into Forex Trading
With forex trading, you gain access to a foreign trading account where you invest your money in other currencies at an interest. The benefit comes when you dispose of your funds to a country with the low-interest rate in what is known as carry trading. It involves picking a currency pair where one currency has a high-interest rate and the other has a low-interest rate. Investors hold it for the high-interest paying currency.
Daily payment on interest difference between the countries is made through a daily rollover. With good leverage, traders can make good returns against the Forex trade capital required. It’s all about being strategic through financial market research!
So, how do these interest rates impact currencies?
Global investors have a keen interest on interest rates. They invest their funds in countries in anticipation of good returns. With increased interest rates, the country’s currency interest also increases. When interest rates are increased for a longer period, there will be an extended trend against market currencies. The money will keep on piling into other currencies and affect returns on investment.
Investments around interest rates are risky and very sensitive. A slight shift in global economies can detrimentally impact on the interest rate trade. This is not a common occurrence but it becomes a disaster when it happens. A typical example is the 2008 financial crisis where high-interest currency pairs went to more than 1000 pips per day. There were a lot of uncertainties in the world economy. The recovery from that economic meltdown was also not smooth as traders experienced smaller flip outs.
A country with a high-interest rate may sometimes be having a falling currency. This is a huge disparity and a clear indication that the interest payable is not worth the associated investment risks. In such a situation, you cannot be sure with the rates as they may go down in no time. If this happens, you may end up getting smaller margins than you had anticipated in your initial investment calculations.
How Often Do Interest Rates Change?
There is an assumption that interest rates will not change quite often. Well, this is true except that the expectations on the slope and direction of rate changes on a weekly basis. This is more especially in the treasury yield and interest rates such as in the 2-Year Government Debt, well exemplified by the US 2-Year Treasury. When doing forex trading, have a clear picture of everything especially on the economic status of the country. Factors that lead to a raise or a lowering of interest rates in that particular country will greatly affect your investment returns.
As a Forex trader, understand more about the country that you are pairing against. As you pair your high-interest currency against any country, you must understand the economic dynamics. You should understand these relations very well. One of the currencies in the pair could be the cause of the shift in interest rates or both of them. This information will help you make good investment decisions.
There are several factors that move a country’s currency. However, interest is among the top factors alongside the risks involved. A good understanding of interest rates and risks will help you navigate the Forex trade and make the most out of the opportunities. Ensure you have sufficient knowledge on your currency pairs and the economic welfare of the two countries, especially the one you are pairing a high-interest currency against.