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Interest Rates in Forex Market

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by , 10-12-2018 at 01:01 PM (351 Views)
      
   
While there are many factors that figure into the valuation of a currency, one of the most important factors to consider is the country’s interest rates.

What to Look For

If we have a relatively stable geopolitical and economic situation around the world, the currency market will naturally favor a currency that is seeing a rise in interest rates and further interest rate hike expectations ahead. Still, interest rates aren’t the only factors that move a currency. Other such factors such as war, geopolitical concerns, inflation, correlations to other markets, and many other things can come into play as well.

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When interest rates are higher, it tends to attract a lot of foreign investment. This is because money always wants to go to “where it is treated the best.” For example, if you run a huge hedge fund, you will be looking for higher yields for your clients. If country A pays 5% on a bond, while country B pays 2% on the same type of bond, then country A is the clear favorite as to where you should be investing. In order to buy that bond, or invest in that financial vehicle, you need to purchase in the host country’s currency.

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Let’s say that you run a large fund out of the United Kingdom. You are instructed to put money to work somewhere, and the most natural place to put a significant amount of your money is going to be where you can find the most growth. Typically, central banks will raise interest rates if an economy is running hot. There is a bit of a timing issue here, but sometimes you may decide to go into a stock market, for which you will need to make purchases in a local currency. The reason for the higher rates is that they are worried about the economy boiling over, but at the same time there is a proclivity for stocks to go higher in that situation. Looking around the world, you decide that Germany is the place that you wish to invest as many of the German multinationals have enjoyed great export growth. In order to buy stocks on the DAX, you will need to buy euros.

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