- AME CAPITALS
- Trading Technology
- Help AME Trading
Part III. Fundamental Analysis / Chapter 3. Types of Interest Rates
As a novice Internet trader, you have likely come across the term "interest rate" and its influence on currency exchange rates in the Forex market. In this chapter, we will explore what seasoned financial market participants mean when they discuss interest rates and the valuable information that can be derived from them. We will specifically focus on the role of interest rates in forecasting currency exchange rates in the Forex market.
The subject of this chapter is directly related to borrowed capital, creditors, and debtors. A creditor is someone who lends money, while a debtor is someone who borrows money. The borrowed capital refers to the amount involved in the transaction. In the world of investments, no one provides loans without expecting something in return. Creditors derive benefits through the interest charged on the loan, which the debtor repays for the use of the credit. You are likely familiar with this scheme if you have ever taken a loan from a bank. In reality, there are different approaches to interest calculation, and the names of the interest rates vary depending on the method used.
Interest Rate: The interest rate is the fee for a loan expressed as a percentage per year. The interest is paid at the time of repayment of the borrowed capital. For example, if you borrow $100,000 for one year at an interest rate of 8%, you will receive $100,000 upfront. At the end of the term, you will need to repay the $100,000 plus the interest on the loan, which amounts to $8,000, making a total of $108,000.
Discount Rate: The discount rate also represents the cost of a loan, but in this case, the size of the loan is reduced by the interest amount. For instance, if you borrow $100,000 for one year at a discount rate of 8%, you will receive $92,000 upfront. At the end of the term, you will still need to repay the full $100,000.
If we compare the two interest rates mentioned above, at the same value, the interest rate is more advantageous for the debtor than the discount rate. Conversely, for the creditor, it is the opposite. In our example, the discount rate of 8% is equivalent to an interest rate of approximately 8.7%.
Now, how does all of this relate to the foreign exchange market (Forex)? It turns out that it has a direct connection. In countries with a dual banking system, where commercial banks are under the control of the central bank (CB), interest rates play a crucial role in the monetary policy of the state. The central bank provides credit to commercial banks at these rates, which forms the basis for ensuring the flow of money within the country.
The main benchmark interest rate in a country is the refinancing rate (official discount rate, ODR) – the primary discount rate at which the central bank provides credit to commercial banks. Foreign investors show greater interest in countries with higher refinancing rates. A high interest rate allows banks to raise deposit rates, making it attractive to invest their excess funds in those banks. However, on the other hand, a high refinancing rate also means high interest rates on loans within the country, which can adversely affect lending to small and medium-sized businesses. This can lead to unemployment and a decrease in the circulation of money (deflation). In other words, an increase in the refinancing rate, on one hand, leads to an appreciation of the national currency due to increased demand for it from foreign investors on the Forex market, but on the other hand, it has a detrimental impact on the country's economy and leads to an increase in unemployment levels. A decrease in the interest rate has the opposite consequences – foreign investors withdraw their deposits, subsequently selling the currency on the Forex market, resulting in a depreciation of its exchange rate. However, low interest rates on bank loans stimulate small and medium-sized businesses, reduce unemployment, and increase the circulation of money (inflation). As we can see, the refinancing rate is a key mechanism for regulating the economy, and central banks skillfully manipulate it for these purposes. The refinancing rate can change multiple times within a month or remain unchanged for many years, depending on the economic policies pursued by the government.
In addition to the refinancing rate, there are other interest rates as well. The Repo rate is an agreement for the sale and repurchase of securities. Central banks use this rate in operations with commercial banks and other credit institutions when buying (accounting for) government treasury securities. Central banks regulate lending capital through this rate.
The Lombard rate is an interest rate applied by central banks when providing loans to commercial banks against the pledge of real estate and gold and currency reserves.
Commercial banks can also lend to each other on a short-term basis using their free funds held in correspondent accounts at the central bank. In this case, the Federal Funds rate comes into play, which is sometimes referred to as the Federal Reserve rate. This rate derives its name from the U.S. central bank, the Federal Reserve System (US Federal Reserve, UFR).
Besides the mentioned interest rates, there are also other rates that apply between commercial banks. They are classified as Interbank Offered Rate (IBOR) and Interbank Bid Rate, reflecting the rates at which banks offer and bid for funds in the interbank market. It is customary to specify the name of the financial center to which these rates apply. The most widely recognized reference rate in the Forex market is the London Interbank Offered Rate (LIBOR).
Despite the variety of interest rate types, the refinancing rate remains the key rate. It is the change in this rate that the Forex market reacts to primarily. This rate may have different names in different countries, but its essence remains the same. When you have open positions in Forex, always stay updated on financial news to avoid missing announcements of interest rate changes in the countries that interest you.