How Interest Rates Make Forex Profitable
Interest rates are one of the major concerns of traders. It is through these that profits are made or lost. Thus, we have to understand how interest rates affect our investments.
How do we profit from interest rates? Here, we use two methods: the interest income and the capital appreciation methods. Hence, the principle in profiting from interest rates is to purchase currencies with high interest rates and then back this up with currencies having low interest rates.
For instance, let's say the US dollar stands at 5.25 percent interest rates against .25 percent of the yen. How can we profit from this rate difference? We may borrow a big amount of yen to purchase US dollars with and then use the dollars to buy bonds or CDs using the US dollar rate of 5.25 percent.
Or, we can opt to borrow at .25 percent interest rate and have this borrowed by another at 5.25 percent. If we subtract .25 from 5.25 this makes a 5 percent profit from the transactions. Or, to make this simpler, instead of money lending and getting entangled through all that transaction, we simply put the investment on a currency pair trade with the same profit.
When interest rates go up currency values also go up. This allows us profitability from the increased value of our currency, or what they call the "capital appreciation." Rates and values going up is a capital appreciation. Hence, in 2006, the dollar interest rates remained stronger than the yen. So, the dollar strengthened in value. Those who traded the Japanese currency for the US currency profited.
As a rule, when a currency value has a broad spread it allows traders an excellent chance to profit through interest income and capital appreciation. Like, in August 2006, the Bank of England increased its short-term price from 4.5 to 4.75 percent while Japan kept its currency interest rates fixed at .25 percent. As a result trade capital poured into the English market. Thus, the demand for pounds went up and so did its value.
Interest rates may be used for trading currencies for the long or short term. With long-term trades we base the trades on major factors or themes. However, with short-term trades, we base the trades on sudden developments in the news that cause a major influence on the currency market interest rates.
Thus, interest rates are a major forex market force that easily tips the balance in favor or against our investment. Hence, we should be aware of developments with regards interest rates.