When you participate in forex trading you should understand that there are a number of factors to changes in a currency pair. The securities used in forex trading are currency pairs which are reflected by the exchange rates between two district currencies. A currency pair is calculated by dividing one currency by another. An exchange rate that includes the dollar is often the most liquid trading instrument.
To understand why currencies move over a long-term, you need to have an understanding of the component that drives currency trading. One of the most influential components of currency trading is the interest rate differential between two countries’ sovereign interest rates. The interest rate differential is the difference between two interest rates of the same tenor. For example, a 2-year yield differential is the difference between the 2-year yield on one country’s interest rates and a second country’s 2-year yield interest rates.
What makes the interest rate differential so important to currency trading is that it drives the movements of the forward market. When you purchase (or sell) a currency pair, you are buying and simultaneously selling a currency. When you buy a currency for a period longer than 2-days, you are in essence earning the interest rate yield on that currency for the period that you are holding the currency. At the same time, when you sell a currency, you are borrowing that interest rate and therefore have to pay away that yield to the person that owns that currency.
As mentioned, the interest rate differential is the difference between the two yields. If you own a currency that has a higher yield than the currency that you are selling, you will earn the difference between the two yields. For example, if you purchase the US dollar and sell the Euro, and your settlement date is in two year from the current date, you will earn a yield differential of 1.3%. On the other hand, if you are long the Euro and short the dollar you will need to pay away the 1.3% during the course of the next two years.
As you can see, it is more attractive to be receiving a yield then paying away a yield and therefore many times, as the interest rate differential moves in favor of a specific currency, that currency becomes more attractive. If you participate in currency trading you should understand how the process of generating a forward curve works via an interest rate differential. The rate differential is used to calculate the forward curve, which directly is incorporated into your forward rate. In the example of the EUR/USD; if you sold this pair with a settlement date of 2-years, your rate would increase by approximately 1.3% a year and that would be the exchange rate you would sell at when consummating the transaction.
If you are participating in forex trading, you should have some understanding of interest rate differentials and what helps drive a currency pair over a period of time.