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.

 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.