Calculating Interest Rate Differentials and Following the Currency Pair Trends

The best way to use interest rate differentials for trading is by keeping track of one-month LIBOR rates or 10-year bond yields in Microsoft Excel.

figure 9.17 USD/CAD and Bond Spread
table 9.1 Bond Spreads

Date

10/29/2004

11/30/2004

12/31/2004

1/31/2005

2/28/2005

U.S. 10-year yield

2.00

2.29

2.40

2.59

2.71

GBP/USD

1.8372

1.9095

1.9181

1.8829

1.9210

U.K. 10-year yield

4.83

4.82

4.86

4.83

4.87

U.K.-U.S. rate differential

2.83

2.53

2.46

2.24

2.15

USD/JPY

105.81

103.07

102.63

103.70

104.63

JPY 10-year yield

0.04

0.039

0.039

0.04

0.038

U.S.-JPY rate differential

1.96

2.25

2.36

2.55

2.67

These rates are publicly available on web sites such as Bloomberg.com. Interest rate differentials are then calculated by subtracting the yield of the second currency in the pair from the yield of the first. It is important to make sure that interest rate differentials are calculated in the order in which they appear for the pair. For instance, the interest rate differentials in GBP/USD should be the 10-year gilt rate minus the 10-year U.S. Treasury note rate. For euro data, use data from the German 10-year bond. Form a table that looks similar to the one shown in Table 9.1.

After sufficient data is gathered, you can graph currency pair values and yields using a graph with two axes to see any correlations or trends. The sample graphs in Figures 9.15, 9.16, and 9.17 use the date in the x-axis and currency pair price and interest rate differentials on two y-axis graphs. To fully utilize this data in trading, you want to pay close attention to trends in the interest rate differentials of the currency pairs you trade.

FUNDAMENTAL TRADING STRATEGY: RISK REVERSALS

Risk reversals are a useful fundamentals-based tool to add to your mix of indicators for trading. One of the weaknesses of currency trading is the lack of volume data and accurate indicators for gauging sentiment. The only publicly available report on positioning is the "Commitments of Traders" report published by the Commodity Futures Trading Commission, and even that is released with a three-day delay. A useful alternative is to use risk reversals, which are provided on a real-time basis on the Forex Capital Markets (FXCM) news plug-in, under Options. As we first introduced in Chapter 7, a risk reversal consists of a pair of options for the same currency (a call and a put). Based on put/call parity, far out-of-the-money options (25 delta) with the same expiration and strike price should also have the same implied volatility. However, in reality this is not true. Sentiment is embedded in volatilities, which makes risk reversals a good tool to gauge market sentiment. A number strongly in favor of calls over puts indicates that there is more demand for calls than puts. The opposite is also true: a number strongly in favor of puts over calls indicates that there is a premium built in put options as a result of the higher demand. If risk reversals are near zero, this indicates that there is indecision among bulls and bears and that there is no strong bias in the markets.

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