How Interest Rates Play a Role in the Currency Markets
Interest rates play the foremost important role in moving the prices of currencies in the Forex market. As the institutions that set interest rates, central banks are therefore the most influential factors. Interest rates dictate flows of investment. Since the currencies are 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.
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 discourage investors from purchasing assets in that particular economy, as the return on their investment is now smaller. The economy's currency will depreciate as a result of the weaker demand.