Domestic rate definition
Domestic rates are defined as the interest rate of currencies in their own countries expressed in real terms. By comparing the interest rates of domestic currency against the rates of foreign currencies, it may be possible for investors to identify opportunities for arbitrage transactions; these allow investors to offset lower interest rates for one currency against higher rates paid by another and derive a profit without significant risk.
Interest rate parity
The concept of interest rate parity deals with the exchange rate for currencies that have different interest rates, and presumes that no guaranteed risk-free profit can be derived through leveraging interest rates against each other on the FOREX market. For instance, if interest rate parity applies, then the returns achieved by borrowing in domestic currency at the domestic rate, then exchanging the domestic currency for foreign currency and purchasing interest-bearing securities at the foreign currency’s prevailing rate should not produce profit or loss for the investor. In reality, this is rarely exactly the case; by researching the current market conditions and offsetting the varying interest rates and exchange rates available, arbitrageurs can often achieve virtually riskless profits in the FOREX market for short periods of time. These profits typically are very small and require large investments in order to make them worthwhile, however.
Effects of domestic rates
Typically, domestic rates are determined by a combination of market factors and governmental oversight. When domestic rates are higher, international investment in bonds and government-backed securities tends to increase, drawn by the higher return on initial investment. However, money becomes tighter within the country, since there is greater demand for a limited supply of circulating currency. This can lead to negative economic effects like layoffs and unemployment, and can hinder companies from obtaining necessary funds, leading to a recession. Lower interest rates tend to discourage international investment, but can allow freer access to funds for companies looking to expand; additionally, these rates can sometimes offer opportunities for arbitrage, allowing companies to profit by international FOREX trades. The FOREX market is the largest and most liquid financial market in the world; because it is so volatile, the value of any currency is usually closely tied to an amount that yields interest rate parity with other currencies traded on the market. While arbitrage opportunities do exist, they are usually of short duration and quickly assimilated into the exchange value of currencies on the overall FOREX market.