How do interest rates affect trading financial markets?

Any budding online entrepreneur will always be looking at ways to make money. One of the most appealing to many is investing in the global financial markets. From putting money into forex to bonds and more, it can be a fast and profitable way to make money online. Before you dive right into investing though, it is worth understanding the role that interest rates play. 

In simple terms, interest rates are the cost of borrowing money and also the return you get on any investments made. Most investors will use a yield curve to work out how much they might get back on any money lent or investment made.

But how do interest rates and the yield curve affect the way that financial markets trade? In essence, they can give traders and investors a great idea about trends in certain assets, such as forex. By looking at interest rates more closely, investors can make more informed decisions before putting any money down. When it comes to using this in a practical way, there are a few different interest rate theories to take on board.

Pure expectations theory 

One of the most well-known formulas around interest rates in trading markets is the pure expectations theory. This logical theory is based on the premise that any interest contract’s term structure solely depends on shorter-term portions when working out the price and rate of assets with a longer maturity. With this theory, you have the same yield expectations and security in buying a single ten-year bond as two five-year ones. 

Liquidity preference theory

Another interest rate theory that many online traders use is this one. It was first devised to look at how yields on shorter-term investments have been observed to be lower than the rates returned on longer-term ones. The risk factor is what leads to an upward slope in the yield curve mostly. Online investors can use this theory when looking at how long to invest for and deciding if a longer-term approach is more profitable. 

Market segmentation theory 

This theory does not suppose that investments of the same class but different lengths are only separated by the return they give. Market segmentation instead treats the maturity term of each asset as being individual and not related. As each separate investment type is taken out by traders with different goals and profiles, market segmentation treats them as such. 

Preferred habitat theory 

The last of the major interest rate theories that online traders can use is the preferred habitat approach. This is similar to market segmentation but ascertains that most investors have a preferred habitat for their trades. This approach says that many investors want a higher premium for debts that take longer to play out as they like to be in the left-hand side of any yield curve. 

Interest rates are key to financial markets

As we have looked at, interest rates play a big role in how financial markets work and how you can make decisions when trading on them. The various theories are also vital as they give you a way to not only interpret what interest rates and yield curves mean but also to predict what any given investment may return.