This article looks at the effect of interest rates on foreign exchange rates and how to handle the movements.
Foreign exchange rates are constantly moving up or down. There are various factors that affect this constant movement. The interest rate is an important factor when it comes to determining forex rates. Interest rates not only affect the return on investment for those who invest in money markets, bonds and other investment types, it also affects those in the foreign exchange trading market.
The differentials in interest rates allow traders to invest money in currencies with high interest rates. To do this effectively, you should pair the higher interest rate currency with a low interest rate currency. This method of trading is called ‘carry trading’. The pair should be held with the high rate currency being the one you are holding. If you intend using daily rollover, you will earn on the variance between the interest rates of the two countries related to your currency pair, on a daily basis. If you make use of high leverage, it is possible for you to obtain a good return on the capital that you needed to enter the trade.
What is the Effect of Interest Rates on Foreign Exchange Rates?
When a country has a high interest rate, it is attractive to investors who are always on the lookout for a high return on their funds. This higher demand for the currency will increase the country’s foreign exchange rates. If the interest rate remains high, this trend could continue for an extended time period. Investors will continue moving their funds into that particular country until such time as they suspect a decrease in rates looming.
Foreign Exchange Trading and Interest Rates
The high risk involved in carry trading is a negative to traders. Factors that are able to affect the economies of countries often cause a massive earthquake like effect on a forex strategy related to interest rates. It does not really happen very often, but when it does, you need to be prepared for it or you could be left in the wreckage. During 2008 when the global financial crisis took place, currency pairs that were linked to currencies with high interest rates were known to move more than 1000 pips daily. This was due to the uncertainty regarding the international economic markets. This trend remained in place for several months after the initial movement. Every time there was a slight movement towards recovery, small disasters occurred.
There are instances where a country may have a high interest rate, but have a currency that is decreasing in value. In this case, there is no point in taking advantage of the interest rate as the risks are too high. In this case, it may be an indication that the country is due to experience a decline in its interest rate in the near future.
If you wish to become a successful foreign exchange trader, you need to be aware of the full picture. You should assess the economic climate of the countries linked to your currency pair and determine the reason behind the increase or decrease in its interest rates. This will prepare you to make an educated decision regarding your investment.
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