Another major component of Forex risk is interest rate fluctuations. We know that when an entity or institution borrows funds from a given lender, the lender will provide those funds in exchange for a given interest rate on the loan.
The rate of interest charged will typically be determined by the amount of risk the lender takes. Usually, borrowers who are considered high risk will pay a higher interest rate on a loan. Conversely, borrowers who have a lower risk profile will invariably pay lower interest rates over the life of the loan.
Central Banks are responsible for setting monetary policies within their counties to ensure economic growth and stability. These fluctuating interest rates in the foreign exchange markets drive numerous decisions for traders.
It is important to note that a country’s interest rates and currency exchange rates are often linked hand and hand. By carefully monitoring interest rate changes, you will know where big institutions are investing their assets in order to receive the greatest return possible.
Many times big institutions focus on the carry trade, which is an interest rate differential based trade. Generally, the higher yielding interest rate currency pairs attract greater demand.