Interest rates are one of the key fundamental forces that move currency prices. At its simplest, an interest rate is the cost of borrowing money and the reward for lending it. In the foreign exchange market that cost and reward shape where capital flows, which in turn affects demand for one currency relative to another. For a trader, interest rates influence longer-term trends, the day-to-day cost of holding positions, and the reaction to major economic news. This article explains how interest rates work in forex, how they show up in trading costs and opportunities, and what to watch for if you trade currencies.
What “interest rate” means in the context of forex
When people talk about interest rates in forex they usually mean the policy rate set by a country’s central bank — the benchmark rate that guides borrowing costs in the economy. Examples include short-term target rates used by central banks to influence inflation and growth. Those benchmark rates affect bank lending rates, bond yields, and other market rates. Traders also pay attention to interbank rates, which are the rates banks charge one another for short-term loans; these feed into the overnight financing costs traders see on their accounts.
It helps to think in two layers. The first is the macro layer: the central bank’s policy rate and the economic conditions that drive it (inflation, GDP growth, employment). The second is the market layer: interbank funding rates, bond yields and the forward market, which determine the actual cost or credit a trader receives when holding a currency position overnight.
How interest rates affect currency values
Interest rates influence currencies mainly through capital flows and expectations. If one country offers higher real returns — after accounting for inflation — investors are more likely to move money there to earn that yield. That increases demand for the country’s currency and tends to push its exchange rate higher. Conversely, lower yields reduce foreign demand and can weaken a currency.
Expectations are as important as the current rate. Markets price in anticipated rate moves well before central banks act. For example, if traders expect a central bank to raise rates next quarter, investors may begin buying that currency now. Often the biggest price moves happen when reality differs from expectations: a surprise hike, a larger-than-expected cut, or a central bank statement that changes the perceived future path of policy.
There’s also a distinction between nominal and real interest rates. Nominal rates are the published rates; real rates are adjusted for expected inflation (real = nominal − expected inflation). From an investor’s point of view, the real rate is what matters for purchasing power and therefore for cross-border capital decisions.
Interest rate differentials and the carry trade
Currencies always trade in pairs, so what matters is the interest rate differential between the two economies in that pair. If the base currency of a pair pays a higher interest rate than the quote currency, holding a long position in that pair can generate an overnight interest credit; the reverse produces a debit. This daily credit or debit is commonly known as rollover, swap, or financing.
One popular historic strategy driven by differentials is the carry trade: borrow in a low-rate currency and invest in a high-rate currency, profiting from the spread. For example, if Country A’s policy rate is 0.25% and Country B’s is 4.25%, a trader might sell the low-yielding currency and buy the high-yielding one to pick up the yield differential. In practice, the trade’s profit depends on both the interest differential and any exchange-rate movement; if the high-rate currency depreciates sharply, exchange-rate losses can wipe out the interest gain.
How rollover (financing) is calculated — a worked example
When you hold a forex position overnight you either earn or pay a financing amount based on the interest differential and the notional size of the trade. The exact formula varies by broker, but the basic idea is straightforward.
Imagine you are long 100,000 units of EUR/USD at an exchange rate of 1.1000 (so the USD value of the position is 110,000). Suppose the annual interest rate for the euro is 0.50% and for the US dollar is 2.50%. Convert the annual rates to daily rates (annual rate ÷ 365). The euro daily rate is roughly 0.50%/365 ≈ 0.0000137; the dollar daily rate is roughly 2.50%/365 ≈ 0.0000685.
You earn interest on the long currency (EUR) and pay interest on the short currency (USD). For the position:
- Interest earned on EUR: 100,000 × 0.0000137 ≈ €1.37 per day, which converted at 1.1000 equals about $1.51.
- Interest paid on USD: 110,000 × 0.0000685 ≈ $7.54 per day.
Net financing = interest earned (converted) − interest paid = $1.51 − $7.54 = −$6.03. That means the account would be debited approximately $6.03 for each day the position is held overnight. Brokers often add a small markup and apply other adjustments, so the actual amount will differ, but the example shows the mechanics.
Brokers also typically apply a triple rollover on one day of the week (often Wednesday) to account for the weekend, and holiday schedules can change how financing is applied.
Trading strategies that use interest rates
Traders incorporate interest-rate information in several ways. A common approach is to trade around central bank announcements and the economic releases that influence policy: inflation figures, employment data, and GDP growth. Some traders try to predict changes in central bank tone by studying forward guidance, minutes, and “dot plots” or similar communications.
Carry trades remain a long-term approach for some traders: position in currency pairs with persistent positive differentials while managing the risk of abrupt reversals. Shorter-term strategies include fading the immediate volatility after an unexpected announcement or waiting for a pullback after a rate surprise before entering in the direction signalled by the new policy outlook. In all cases, most successful traders combine a fundamental view on rates with technical signals to time entries and exits.
Practical ways to follow interest-rate drivers
To follow interest-rate developments, keep an eye on central bank calendars, regular policy meetings, and the key economic releases that typically influence decisions: consumer price data (CPI/PCE), employment reports, and GDP readings. Central bank speeches and post-meeting statements often contain clues on future policy. Market-implied tools such as forward rates and futures can show how traders are pricing future rate moves; divergence between market pricing and central bank communication is often a source of volatility.
Watch not only headline rate changes but also the language used by policymakers. A “hawkish” tone suggests a bias toward higher rates; a “dovish” tone leans toward cuts or prolonged low rates. Because markets frequently price expectations ahead of meetings, pay attention to the consensus expectations and the actual result — mismatches create the biggest immediate moves.
Risks and caveats
Trading on interest-rate differences and around rate announcements carries several risks. Exchange rates can move quickly and unpredictably, and leverage common in retail forex trading amplifies both gains and losses. A carry trade that looks attractive because of a high interest differential can lose money rapidly if the higher-yielding currency falls in value. Financing rates shown by brokers are not the same as central bank rates; they reflect interbank rates, hedging costs and broker markups, and these can change over time. Overnight financing can add up if positions are held for a long time, and the calendar treatment of weekends and holidays (triple rollover days) can create larger-than-expected charges.
Another practical caveat is that markets often “price in” expected rate moves well before they happen. Because of that, the announcement of an anticipated hike or cut may cause less movement than a surprise result, and sometimes a policy decision that matches expectations still moves the market if the central bank’s language changes the perceived future path. Always use appropriate position sizing, risk management tools such as stop-loss orders, and consider practising strategies in a demo environment before risking real capital.
Trading carries risk; this article is for educational purposes only and does not constitute personal financial advice.
Conclusion
Interest rates are central to how currencies are valued and to the cost of holding forex positions. They matter both for the structural, long-term picture — through capital flows and real yields — and for short-term trading through rollover costs and central bank-driven volatility. Understanding interest-rate mechanics, differentials, and how markets form expectations will help you interpret currency moves more clearly and manage trades with greater awareness of the hidden costs and risks.
Key Takeaways
- Interest rates influence currency demand through capital flows and expectations; real rates (nominal minus inflation) are especially important.
- Interest rate differentials determine daily rollover credits or debits and are the basis for carry trades, but exchange-rate moves can offset yield gains.
- Financing on overnight positions is calculated from interbank rates and position size; brokers may apply markups and triple rollovers for weekends.
- Trading around rates requires strict risk management: markets can price expectations early and react sharply to surprises.
References
- https://capitalxtend.com/forex-academy/forex/interest-rate-trading
- https://www.schwab.com/learn/story/how-to-calculate-financing-rates-on-forex-trades
- https://www.ig.com/en/trading-strategies/how-do-interest-rates-and-inflation-affect-forex-230117
- https://www.forex.com/en/trading-academy/courses/advanced-trading-strategies/interest-rate-trading/
- https://www.ig.com/en-ch/learn-to-trade/ig-academy/a-beginners-guide-to-forex-trading/interest-rates-and-forex
- https://www.ig.com/sg/ig-academy/a-beginners-guide-to-forex-trading/interest-rates-forex-market
- https://www.babypips.com/learn/forex/interest-rates-101
- https://www.oanda.com/us-en/trade-tap-blog/asset-classes/forex/how-interest-rates-affect-currency-pairs/