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 Dictate Investment

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 simple example:

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.