Why do Interest Rates impact currency rates?

Interest rates (and more importantly the markets' perception of future interest rates) have a direct impact on currency exchange rates. A currency offering a high interest rate (a "high yielding" currency) often attracts buying of that currency, making it strengthen against other currencies. Currencies offering low interest rates (or where interest rates are falling) often suffer from low demand and weaken as a result. This has been the case with Sterling over the last month (as of November 2008).

Another important factor to consider is that currencies offering a high interest rate also are likely to have high inflation and a riskier economy. Like all other investments/assets, higher reward (in yield) is usually accompanied by higher risk. Therefore when risk aversion rises, investors will sell high yielding/risky assets, which makes high yielding currencies fall in value.