Macro & Central BanksPolicy RateBase Rate
Interest Rate
The price of borrowing money, expressed as a percentage per year, with the central bank's policy rate anchoring the whole structure.
What Interest Rate means
An interest rate is the cost of borrowing or the reward for lending, quoted as an annual percentage. The rate that matters most to currency traders is the policy rate set by a central bank, such as the federal funds target range in the United States, the deposit facility rate in the euro area, or Bank Rate in the United Kingdom. That single administered rate anchors overnight bank funding and then propagates outward through money-market rates, government bond yields, mortgages and corporate credit, shaping the returns available on assets denominated in the currency.
Exchange rates respond less to the current level of rates than to expected changes in them. Capital tends to flow toward currencies where the expected policy path is being revised upward relative to elsewhere, so what drives a pair is the interest rate differential and how that differential is expected to evolve. Rate differentials also determine the swap or rollover a broker applies to positions held overnight. The practical caveat is that policy expectations are usually priced well in advance, so a rate change that markets fully anticipated often produces very little movement on the day.
Worked example
If the expected policy path in the United States is revised half a percentage point higher relative to Japan, the widening differential typically pushes USD/JPY up, for instance from around 152.40 toward 155.00 over the following weeks. Illustrative only.
Related terms
- Central BankThe public institution responsible for a currency's monetary policy, issuance and financial stability.
- Bond YieldThe annual return an investor earns on a bond given its price, which moves inversely to the bond's price.
- Carry TradeA strategy of holding a higher-yielding currency against a lower-yielding one to earn the interest differential.
- Interest Rate ParityThe no-arbitrage relationship linking spot and forward exchange rates to the interest rate differential between two currencies.
- SwapThe interest credited or debited for holding a forex position overnight, based on the two currencies' rate differential.
Frequently asked questions
What does Interest Rate mean in forex trading?
The price of borrowing money, expressed as a percentage per year, with the central bank's policy rate anchoring the whole structure.
How does Interest Rate work in practice?
Exchange rates respond less to the current level of rates than to expected changes in them. Capital tends to flow toward currencies where the expected policy path is being revised upward relative to elsewhere, so what drives a pair is the interest rate differential and how that differential is expected to evolve. Rate differentials also determine the swap or rollover a broker applies to positions held overnight. The practical caveat is that policy expectations are usually priced well in advance, so a rate change that markets fully anticipated often produces very little movement on the day.
What is an example of Interest Rate?
If the expected policy path in the United States is revised half a percentage point higher relative to Japan, the widening differential typically pushes USD/JPY up, for instance from around 152.40 toward 155.00 over the following weeks. Illustrative only.
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