How Interest Rate Changes Affect the Forex Market

Interest rates consist of perhaps the most significant determinant of foreign exchange rates. Furthermore, when it comes to considering how interest rate levels and their changes tend to affect the forex market, economic analysts generally look not at the real interest rate prevailing in a country, but instead at the nominal or benchmark interest rate set by a country’s central bank.

In practice, forex rates usually trend over the medium and longer term to favor the currency with the higher nominal interest rate. Furthermore, central banks set benchmark nominal interest rates to reflect their stance on monetary policy.

As a result, hawkish statements from monetary policymakers indicating higher nominal interest rates for the country tend to benefit its currency well in advance of any actual movements seen in nominal interest rates.

Interest Rate Parity

Another useful concept involving the relationship between interest rates and foreign exchange rates is known as interest rate parity. This idea basically postulates the equality of fully-hedged returns obtained from making investments in different currencies.

This means that such returns would not depend on the actual levels of interest rates seen in the different currencies. This parity concept generally requires efficient international markets with no barriers to investment flows to hold true.

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Interest Rate Differentials

As the name implies, the interest rates differential between a currency pair is readily determined by taking the difference between the interest rate prevailing in the first currency’s country and the interest rate seen in the second currency’s country.

If each country is perceived as sufficiently safe for investment, international capital flows soon move in to take advantage of any such differential by seeking to make deposits at the higher rate. To do so, managers of such fluid funds first need to purchase the higher-rate currency, and so demand for that currency gradually increases. Eventually, this will result in that currency’s appreciation against the lower-rate currency.

Since interest rate differentials are used to price foreign exchange forward outrights, currency futures and forward swaps, in addition to European-style currency options, any changes in these differentials will impact not just the pricing seen in the spot market for affected currency pairs, but also the forex forward and option markets.

Carry Trades

Interest rate changes also affect the attractiveness of carry trades involving the currency for which the interest rate has changed. Basically, carry trades involve borrowing in a low interest rate currency to invest in assets denominated in a higher interest rate currency in the hopes of capturing the interest rate differential. Such trades generally involve taking foreign exchange risk.

Carry trades can be done via the forex market by entering into a forward outright contract to buy the high interest rate currency and sell the low interest rate currency. Such a contract will usually be priced at a discount relative to the current spot rate to account for the interest rate differential.

If the spot rate does not move, gains will gradually accumulate on this position over time. Eventually, the carry trader wants the spot rate to end up at a level worse than the rate on the forward contract when it is two business days from delivery so that they can close out the contract for a profit.