The Role of Central Banks in Forex Trading

A country’s economy changes based on various factors, such as the latest natural disaster, international event, or national headline—its current state defined by the value of its currency in the global economy.

This allows traders from that country to make favorable (or unfavorable) deals, depending on the exchange rates that are determined by the apex financial institution in any country, the central bank.

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What Is a Central Bank?

The foreign exchange (forex market) is the world’s largest financial market, its total value of daily trades dwarfing even stock markets. The 2019 Triennial Central Bank Survey of FX and OTC derivatives markets estimated that $6.6 trillion of value was traded in forex daily that year. The central bank’s role is to fix its own currency’s price in the forex market for a nation (or group of nations), through the following pathways:

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Setting Interest Rates

The central bank always decides interest rate policies. Lower interest rates generally encourage investors to borrow money, while higher interest rates encourage (and sometimes even enforce) savings.

The central bank tracks economic indicators constantly, making changes to interest rates that immediately affect the market. Traders should constantly track major announcements from the central bank and look for indicators of whether the interest rates will rise or fall.

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Open Market Operations

Central banks can also rely on Open Market Operations (OMO) to influence the supply of a currency. In the U.S., the Federal Reserve is the nation’s central bank. It purchases U.S. Treasury securities in the open market when it wishes to increase the money supply and sells them to reduce it.

A central bank can protect the currency from economic shocks using OMOs. The central bank’s activity in OMOs also affects the interest rates.