The best thing about trading on the international market of currency exchange is that you are able to trade with leverage. This means that you can borrow as much as 1,000 times your capital to make a deal Nevertheless, borrowing money for trading on Forex is similar to borrowing money for any other purpose –you will have to pay interest on the loan. Since Forex trading involves both buying and selling, the interest on your loan may be offset by the interest made on the currency you purchase Let’s find out what are interest rates in general, to understand how the Forex market is affected by them.
Central banks set interest rates in accordance with their national monetary policy – high interest rates would make the national currency more expensive to purchase, while lower interest rates make it less so. If you imagine the government of a country having high inflation, it would help you realize how interest rates are used.
The government, witnessing the rapidly rising prices, may take a decision to raise interest rates, which is supposed to increase the cost of the national currency, and make demand and consumption drop, because borrowing would become more expensive.
In return, this would cause prices to fall, while inflation rates would decrease In the same manner, if a country undergoes recession, it may lower interest rates in order to boost the national economy, because lower price of currency would cause demand and supply to increase.
The interest rates set by central banks define at what rate commercial banks can borrow money from the governments and lend them to their customers. This includes Forex traders, and that’s where interest rates start affecting the trade.
If you, for instance, want to purchase EUR/USD, you will need to borrow the dollars in order to buy the Euros and therefore pay interest on the dollars and earn it on the Euros If the interest rate set for Euro is higher than that for the American Dollar, you will earn more on the Euros you bought than you pay on the dollars you borrowed This means a profit for you.
But unless there is a considerable difference between the interest rates, the net profit or loss would be marginal. In addition, while interest rates are set on an annual basis, trading positions are normally opened for short periods to considerably lower any gain or loss on interest rates.