Interest rate differentials play a crucial role in determining the relative value of currencies in the foreign exchange market. When one country offers higher interest rates compared to another, it tends to attract foreign investment. This increased demand for the higher-yielding currency leads to appreciation.

Conversely, a country with lower interest rates may see a decrease in foreign investment, reducing demand for its currency and potentially leading to depreciation. Central banks often manipulate interest rates to manage inflation and stimulate economic growth, which, in turn, affects currency values.

These differentials are closely monitored by traders and investors, as they provide insights into potential currency movements and investment opportunities. However, it is important to note that interest rate differentials are just one factor influencing currency markets; other factors such as economic growth, political stability, and global events also play a significant role.