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Forex And Interest Rates – Analyzing The Impact Of Foreign Interest Rates

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Introduction

 

 

One of the most popular forex trading strategies is the carry trade.

This strategy capitalizes on the difference in interest rates among countries.

Interest rates differ from country to country. This means you may be able to borrow money at a low rate in one country and invest in country with a higher interest rate.

In this lesson, we will be discussing forex and interest rates of foreign countries.

You’ll also learn how a carry trade is constructed, how these trades can earn interest, and what risks are associated with this type of trade.

 

But before we begin, we would like you to read and agree to the Terms & Conditions of this post before you proceed any further.

Disclaimer: Invest In Wall Street is in no way financially or legally responsible for any investing decisions made by any of our readers and are, in turn, acting on their own free will. The information in this article is purely educational and should not be abused or misconstrued in any way, shape, or form.

 

Forex Interest Rates

 

 

Let’s start with interest rates.

There are many factors that influence interest rates, such as economic growth and inflation.

These factors can change depending on a country’s monetary policy.

Monetary policy is when a country’s central bank manipulates short-term interest rates to help promote economic growth, maximize employment, and maintain steady consumer prices.

 

 

For example, if Japan’s Central Bank is trying to stimulate the economy, it will reduce interest rates to encourage borrowing and spending.

At the same time, the Bank Of Canada may be concerned about rising inflation.

To combat inflation, Canada’s Central Bank may choose to raise interest rates. This will encourage people to spend less and invest or save more.

So how does this work?

 

 

Let’s run through a simplified example to illustrate the concept.

Suppose a trader borrows money from Japan for 1% and invests in Canada for 3%.

If a trader bought the Canada/Japan currency pair, he is long the Canadian dollar and short the Japanese yen.

Basically, the trader is borrowing money from Japan and investing it in Canada, which creates a carry trade.

 

 

The carry trade in this example resulted in the trader earning 2% interest.

Each day the trader will receive the interest earned, and it will be added to whatever profit or loss the trader experienced from the currency’s pair change in price.

The carry trade is one reason interest rates are so important in the forex market.

When a divergence of interest rates occurs, billions of dollars are commonly redirected to capitalize on it.

This influx of investment will commonly drive up the value of the long currency and drive down the value of the short currency.

 

 

In our example, this means we would expect the Canadian dollar to rise in value against the Japanese yen. However,
there’s no guarantee that a currency pair will appreciate.

For example, if a policy change was enacted and the Bank of Japan pushed interest rates higher, the pair would probably depreciate.

Even if the divergence in interest rates remained significantly high, the interest gained could be offset or even overwhelmed by price depreciation.

 

 

Consequently, many traders only focus on carry trades when the price trend is in their favor.

The expectation is that this will reduce the chances of the price moving against them, canceling the benefits of interest payments.

 

 

Adding to the complexity, some currency pairs must be shorted in order to collect the interest payment.

If the European Central Bank was paying 1%, and the US Treasury was paying 3.5%, you would have to short the European/US pair to collect interest.

Its also important to realize that when trading a currency pair, you may be required to pay interest.

For example, suppose our trader wants to trade an upward trending pair. To do this, he’ll have to cut into his profits because he’ll be required to pay interest.

 

 

Traders should also know that not all accounts qualify for interest payments.

Often micro and mini accounts don’t receive interest.

Traders should check with their dealers to clarify which accounts are available to collect interest.

Understanding the influence of interest rates on currency pairs can help you determine which pair to trade and how to potentially increase returns by collecting interest.

 

 

Quick Recap

Forex And Interest Rates

 

  • There are many factors that influence interest rates, such as economic growth and inflation
  • These factors can change depending on a country’s monetary policy
  • Monetary policy is when a country’s central bank manipulates short-term interest rates to help promote economic growth, maximize employment, and maintain steady consumer prices
  • When a divergence of interest rates occurs, billions of dollars are commonly redirected to capitalize on it
  • This influx of investment will commonly drive up the value of the long currency and drive down the value of the short currency
  • Even if the divergence in interest rates remained significantly high, the interest gained could be offset or even overwhelmed by price depreciation
  • Consequently, many traders only focus on carry trades when the price trend is in their favor
  • The expectation is that this will reduce the chances of the price moving against them, canceling the benefits of interest payments
  • Adding to the complexity, some currency pairs must be shorted in order to collect the interest payment
  • Its also important to realize that when trading a currency pair, you may be required to pay interest
  • Traders should also know that not all accounts qualify for interest payments
  • Often micro and mini accounts don’t receive interest
  • Traders should check with their dealers to clarify which accounts are available to collect interest
  • Understanding the influence of interest rates on currency pairs can help you determine which pair to trade and how to potentially increase returns by collecting interest

 

The Forex “Carry” Trade

 

  • You first take capital from one currency and “carry” or invest it in another currency
  • You want to borrow capital (currency) from the country that is lowering interest rates and “carry” or invest in the following country that is raising their interest rates
  • You would have to do this for an associated currency pair for this to work
  • i.e. – A trader is borrowing money from Japan and investing it in Canada, which creates a carry trade
  • The trader can then profit from interest and it will be added to whatever profit or loss the trader experienced from the currency’s pair change in price

 

 

 

 

 

As you can already tell – and most likely already know, interest rates have a large impact on the forex currencies, which can subsequently cause them to appreciate and depreciate in value.

These interest rates are created due to the ever-changing monetary policies that countries legislate at the end of each financial quarter as a way to help facilitate economic growth or lessen the impacts of other economic scenarios such as inflation and recessions.

It is through this that forex traders can use the knowledge of foreign interest rates to their advantage in order to profit from diverging interest rates from a currency pair.

A common technique that is used to profit from the interest incurred is the forex carry trade (explained in further detail above) which allows the investor to take advantage of diverging interest rates from a single currency pair.

While this is a relatively good strategy, results are not guaranteed so it is important that – especially with forex investing and/or trading – you have a deeper understanding of international politics, foreign affairs and economic policies of the currencies you’re hoping to trade before risking any capital in the foreign exchange (forex) market.

Now it’s not a necessity to have all of these characteristics to invest or trade these assets – although, it will make the investing much easier – but there are people who choose to invest in these assets and have been able to reap profits regardless.

But if you’re really serious about forex investing – then it probably won’t hurt to tune in to the world news every now and then to find out more about the economic foreign policies that may affect the strength of international currencies…..

I hope you have enjoyed this post and found the information to be quite useful. If you have any questions or concerns, please feel free to leave them down in the comment thread below and make sure to like and share this post.

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