Interest rates play the most important role in moving the prices of currencies in the foreign exchange market. As the institutions that set interest rates, central banks are therefore the most influential actors. Interest rates dictate flows of investment. Since currencies are the representations of a country’s economy, differences in interest rates affect the relative worth of currencies in relation to one another. When central banks change interest rates they cause the forex market to experience movement and volatility. In the realm of Forex trading, accurate speculation of central banks’ actions can enhance the trader's chances for a successful trade.
Interest rates can be simply defined as the amount of money a borrower must pay to a lender in order to hold their money. In a simple representation of the foreign exchange market, the lender is an investor holding cash or assets and the borrower is a bank inside a particular country. The lender (investor) provides money to the borrower (the bank) and will receive, after a specific time period, interest in conjunction with the original sum he or she put in. Typically, interest is applied as an annual rate or percentage of the amount being lent. In forex trading interest is credited on a daily basis.
A US investor, Jane, wants to place 100 dollars into a savings account with either a domestic or a foreign bank. The US bank’s interest rate is 5.25%. In Japan, the interest rate for a savings account is 0.25% and in New Zealand it is 7.25%. In considering the best investment after a year, Jane can get back $105.25 investing in the US, $100.25 in Japan, and $107.25 in New Zealand. Opening an account and “lending” money to a New Zealand bank is the investment option that achieves the biggest return for Jane.
Jane’s investment decision shows that higher interest rates attract capital. As a result central banks may attempt to draw foreign investment to their countries through higher interest rates.
An increase in interest rates encourages traders to invest within that market and causes the demand for the currency to rise. As demand rises, the currency becomes scarcer and consequently more valuable. Investors are drawn to the currency, causing it to appreciate, because they will gain a higher yield on their investments, as in the Jane example. In order to purchase the country's assets (stocks or bonds), Jane will have to convert her domestic currency to the target country's currency also increasing demand. Conversely, a fall in interest rates dissuades investors from purchasing assets in that economy, as the return on their investment is now smaller. The economy's currency will depreciate as a result of the weaker demand.