David Waring

In our last lesson we continued our discussion on what moves the forex market with a look at something which is known as the balance of payments. Now that we have an understanding of how trade flows and capital flows interact with one another to establish the longer term direction of a currency, we are going to continue our free forex course with a look at some specific examples from the current market environment, starting with an explanation of how interest rates move the forex market.

Like current and future earnings prospects are the most important factors to consider when trying to forecast the long term direction of a stock, current and future interest rate prospects are the most important factors to consider when trying to forecast the long term direction of a currency. Because of this fact, currencies are highly sensitive to any economic news that can affect the country's interest rates, an important factor for traders of all time frames to understand.

As we learned in module 8 of our free basics of trading course located in the free course section of InformedTrades.com, when the central bank of a country raises interest rates this not only affects the short term rate that they target, but the interest rates for all types of debt instruments. If the central bank of a country raises interest rates then debt instruments of all types are going to become more attractive to investors, all else being equal. This not only means that foreign investors are more likely to invest in the debt of that country, but also that domestic investors are less likely to look outside the country for higher yield, creating more demand for the debt of that country and driving the value of the currency up, all else being equal.

Conversely, when a central bank lowers interest rates, then interest rates on all types of debt instruments for that country are going to be less attractive to investors, all else being equal. This not only means that both foreign and domestic investors are less likely to invest in the debt of that country, but that they are also more likely to pull money out to seek higher returns in other countries, creating less demand for, and a greater market supply of that currency, and driving its value down, all else being equal.

Once this is understood, it is next important to understand that foreign investors are exposed to not only the potential profit or loss from interest rate changes on the debt instrument they are investing in, but also to profits and losses which result from fluctuations in the value of that country's currency. This is an important concept to understand, as it generally will work to increase the profits for investors when interest rates increase, as the increase in the value of the currency is realized when they sell the investment and convert back into their home country's currency. This gives the foreign investor that much extra return on their investment, and that much extra incentive to invest when interest rates rise, driving the value of the currency up further all else being equal.

Conversely when interest rates decrease, there will be less demand for the debt instruments of a country not only because of the lower yield to investors, but also because of the decrease in the value of the currency that normally comes with a decrease in interest rates. The additional whammy of a loss to the foreign investor from the currency conversion that results as part of the investment, further incitivizes them to put their money elsewhere, decreasing the value of the currency further, all else being equal.

That's our lesson for today, in our next lesson we will help drive this point home with an example of this exact situation at work in today's market environment, so we hope to see you in that lesson. As always if you have any questions or comments please leave them in the comments section below, and good luck with your trading.

forexer

Quote:Once this is understood, it is next important to understand that foreign investors are exposed to not only the potential profit or loss from interest rate changes on the debt instrument they are investing in, but also to profits and losses which result from fluctuations in the value of that country's currency. This is an important concept to understand, as it generally will work to increase the profits for investors when interest rates increase, as the increase in the value of the currency is realized when they sell the investment and convert back into their home country's currency. This gives the foreign investor that much extra return on their investment, and that much extra incentive to invest when interest rates rise, driving the value of the currency up further all else being equal.

From my perspective, when the interest rate increases, the value of that currency increases as well due to more foreign and local investments.
This is something like a snowball effect.

However, what i'm unsure off is how foreign investors earn profits when they "sell the investment and convert back into their home country's currency."

Hope to hear from you soon...

David Waring

Hey Forexer,

Glad to hear from you.

Yes you are correct that this can be like a snowball affect. As for your question lets assume that we have an Australian who decides to invest $100,000 in the United States stock market for example. Because the Australian has Australian Dollars he or she will need to convert those Australian Dollars into US Dollars to invest in the US Stock Market. Next lets say that at the time this investment is made, the exchange rate for AUD/USD is .7000 meaning that .7000 USD buys 1 AUD. So the Australian converts 142,857 Australian dollars into 100,000 US Dollars to invest in the US Stock market.

Next lets say that 1 year later the investment that the Australian made in the US Stock market has not really gained or lost anything so he or she gets fed up with it and decides to sell their investment for 100,000 US Dollars.

Over that same year however the US Dollar has strengthened against the Australian dollar so that the exchange rate has fallen from .7000 to .6000. This means that when the Australian converts their US Dollars back to Australian Dollars instead of getting back the original 142,857 Australian Dollars that they originally converted, they will get back 166,666.

So, although the investment in the US Stock market did not make them any money, because of the favorable exchange rate move they have made a profit of 23,809 australian dollars on this investment.

Let me know if that does not make sense or if you have any other questions.

Best Regards,
Dave

__________________
My Free Courses: Forex Course - Stock Course - Futures Course - Basics of Trading - Subprime Crisis - Prorealtime Charts

Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

forexer

Hi David,

I thought in a currency quote, say AUD/USD is .7000, .7000USD = 1AUD.
Like how much of the counter currency equals per base currency.

Hope to hear from you soon...

David Waring

Hey Forexer,

I was looking for a way to make the numbers easy to understand and made a stupid mistake here. You are correct the quote is how many US Dollars it takes to buy 1 AUD not the other way around. I have updated the post to reflect this, my apologies for the error there.

Best Regards,
Dave

__________________
My Free Courses: Forex Course - Stock Course - Futures Course - Basics of Trading - Subprime Crisis - Prorealtime Charts

Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

zoglchaim

they cut rate by 100 points
why is gbp going up right now
baised on that it should go down in value

by the way i enjoy your videos alot thank you so much for posting them it very educational. it by far the best educational web site

David Waring

Hi zoglchaim,

Glad to hear from you and thank you for the kind words I am glad you like the site.

It is important to understand when trading any financial instrument, that markets anticipate, meaning that market news which is expected to occur is normally priced into the market long before the actual news comes out.

While this is a large rate cut by the BOE, this is also what the market expected and as you can see from the longer term pound chart the
sterling has sold off significantly already as a result of this.

As for why it rallied on the news there are a number of possibilities including people waiting on the sidelines to make sure that they did not surprise and cut by more than expected before joining the short term uptrend that has been in place for the last few trading sessions.

Hope that helps.

Best Regards,
Dave

__________________
My Free Courses: Forex Course - Stock Course - Futures Course - Basics of Trading - Subprime Crisis - Prorealtime Charts

Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

Ilivebythesea

Hi Dave

As ever - great explanations and video presentations - thanks

With regard to Central Banks lowering interest rates - this often leads to a rally in domestic stock prices as borrowing money for domestic firms becomes cheaper, potentially stimulating profits, increasing dividends etc.

How much does the increased attractiveness of the domestic stock market act to offset the likely fall in a country's currency - as foreign investors buy the local currency in order to chase the increased returns?

Perhaps this is more relevant to country's such as the UK that are net importers rather than exporting nations such as Germany?

I'd be interested to know your thoughts on this.

David Waring

Hi Ilivebythesea,

Glad to hear from you.

Generally for most dveloped countries the debt markets are many times larger than the equity markets. With this in mind, regardless of whether a country is an importer or exporter, generally flows into the equity markets under the scenario you have outlined are no where near enough to offset.

Hope that helps.

Best Regards,
Dave

__________________
My Free Courses: Forex Course - Stock Course - Futures Course - Basics of Trading - Subprime Crisis - Prorealtime Charts

Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.

Unregistered

since foriegn investors invested into a country it means that the country that they are investing in has a higher interest rate or that they see the interest rate is going to rise.because of this you would assume that there home currency where they live must be lower or declining because it would make more sense for someone to invest in someting that looks like its going to rise.so when they sell their investment in that other country they invested in they are recieving it in the dollars of that country.when it is converted back to the currency of their home country that is lower they would be getting more.