The relationship between interest rates and foreign exchange rates is very difficult yet crucial for successful forex trading.
To make money in forex trading, traders need to understand how interest rates affect forex trading and how they can build strategies to reduce the effects of interest rates on foreign exchange rates.
In this article, we are going to cover:
- What is ‘Foreign Exchange Rate’?
- Why do Interest rates change?
- What are the factors that influence interest rates in India?
- How interest rates affect Forex Trading?
What is ‘Foreign Exchange Rate’?
The foreign exchange rate is the value of one currency in another currency. Foreign exchange rates are quoted in currency pairs like USD/EUR, INR/JPY, EUR/GBP etc.
It is generally stated as:
Foreign Exchange Rate = Base Currency / Vehicle Currency
i.e. USD/INR = 73.61
USD is the base currency, which is always fixed at 1 unit & INR is the vehicle currency.
In short, the foreign exchange rate is the rate at which you can buy and sell currency pairs. So, if the USD/INR rate is 73.61 then it means that you can buy 1 USD with 73.61 Indian rupees.
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Foreign Exchange Rates are of two types:
- Fixed/Pegged Exchange Rates: This happens when a country’s currency doesn’t vary according to the fluctuations in the open forex market because its government (central bank) sets and maintains the official exchange rate at a fixed value.
- Floating Exchange Rates: In the case of the floating exchange rate, the market forces of supply and demand determine the value of the currency pairs.
Why Do Interest Rates Change? What are the Factors that Influence Interest Rates in India?
Before we understand how interest rates affect forex trading, let us first understand which factors influence interest rates in India.
1. Central bank: The Reserve Bank of India highly influences interest rates in India with its quarterly review of interest rates.
- RBI increases the interest rates during inflationary periods. This reduces the consumption and investments driven by borrowed money.
- During recession, RBI reduces interest rates, which encourages people to borrow more and invest in productive avenues.
2. Demand for money: In a growing economy, money is in demand. This high demand for money also influences interest rates.
- Manufacturing sector companies and industries need to borrow money for their short-term and long-term needs of investing in production activities. But when an economy isn’t doing that well, companies avoid borrowing if the demand for their products is low.
- Citizens need money for fulfilling their financial goals. However, in a bad economy, consumers spend less resulting in low demand for money.
To summarise, higher the demand for money, higher the interest rates.
3. Supply of money: As per the law of demand and supply, low demand and high supply lead to falling prices. Similarly, if the supply of money increases, other things remaining the same and there is low demand, interest rates go down.
During recession, the interest rates tend to go down. The ideal example is the Covid 19 pandemic, where the interest rates on bank deposits have fallen from 6.25% to 4.25%
4. Fiscal deficit and government borrowing: Fiscal deficit is the result of government expenditure exceeding government revenue and to fund this deficit, the government resorts to borrowing.
Accordingly, the government’s borrowing influences the demand for money and in turn causes fluctuations in the interest rates.
Higher the fiscal deficit = higher the government borrowing = higher the interest rates.
5. Inflation: The prices of all goods and commodities fluctuate in line with the general price increase in the economy, i.e. inflation.
When the price rises, each unit of currency can buy fewer goods and services than before, implying a reduction in the purchasing power of the currency.
So, people with surplus funds demand higher interest rates, as they want to protect the returns of their investment against inflation.
As a result, with rising inflation, interest rates tend to rise and tend to fall when inflation declines.
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How Interest Rates Affect Forex Trading?
Currencies are directly affected by interest rates as interest rates dictate the flow of global capital in and out of the country.
Let us understand how interest rates affect forex trading with a simple example:
If you had a choice between a bank deposit offering 7% interest rate and another offering a 5% interest rate.
Which one would you choose?
Without a doubt, you will choose the bank deposit offering 7%
Currencies work the same way!
- The higher a country’s interest rate, the stronger the currency.
- Currencies with lower interest rates are more likely to weaken over the longer term.
The FII’s will pour their money into countries with a strong economy so that they can earn good returns.
Interest Rates Expectation
Most forex traders don’t spend their time focusing on current interest rates because the market has already “priced” them into the currency price. What is more important is where interest rates are EXPECTED to go.
- If interest rates of a country go up, the FII’s interest in that country’s currency goes up.
- Also, anything that could affect economies globally can tremble interest rates. This type of situation doesn’t occur often, but when it does, it causes disaster like the COVID-19 pandemic.
Interest Rate Differentials
Pick any currency pair and observe it.
- Many forex traders use this technique of comparing one currency’s interest rate to another currency’s interest rate to analyse whether a currency is strong or weak.
- The difference between the two interest rates, known as the “interest rate differential”.
- The increase in the interest rate of one currency combined with a decreased interest rate of the other currency is the perfect equation for sharp swings!
Sometimes a country will have high-interest rates and a falling currency. Such a disparity is usually an indication that the amount of interest they are paying isn’t worth the risk required or it can indicate that there are signs that rates will be lowered soon.
Higher interest rates usually lead to a higher currency value while lower interest rates usually lead to a lower currency value.
When the interest rates are rising in one country, investors from all around the world will buy that country’s currency. This flow of money has a great influence on the value of that currency as the buying interest rate pushes up the value of that currency.
We hope this article helped you understand the effect of interest rates on forex trading. It is important for you to understand the movement of currencies to become a successful forex trader. Another important prerequisite for successful forex trading is to open a currency trading or Forex trading account with the best discount forex broker in India, Samco.
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