Interest Rate Spread
Forex traders base their decisions to buy or sell certain currencies on the economic factors underlying the associated countries. They keep an eye on both the macro-economic and micro-economic factors that may impact the value of these currencies. Interest rates are the most watched and followed piece of data that affects markets.
Interest rates are nothing more than rates offered by the central banks for very short term bonds. These rates are reset at regular intervals based on a number of local and international factors. Generally, the currency with the higher interest rate will attract more buyers than the one with the lower interest rate.
StraddleTrader Pro Traders, who are long in the currency with the higher interest rate, stand to gain the difference between the two rates. This concept is known as the Carry Trade in Forex. For example, the Australian interest rate currently stands at 4.75%, and the US rate is 0.25%. So, the interest differential is 4.5% in favor of the Australian dollar. If a trader is long the Aussie dollar, they will stand to earn 4.5% per annum on their investment in the carry trade, if the interest rates hold.
Interest rate differential between the two currencies determines to a large extent which currency will be favored. However, the more important aspect is the whether this differential is widening or reducing. A smart trader will also look beyond the obvious to the real reason why there is such a differential in the first place.