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.
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How Interest Rates Play a Role in the Currency Markets
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), one will have to convert his/her domestic currency to the target country's currency also increasing demand. Conversely, a fall in interest rates dissuades investors from purchasing assets in that economy, as the return on their investment is now smaller. The economy's currency will depreciate as a result of the weaker demand.