Fundamental analysis Macroeconomic indicators

The Influence of Changes in Interest Rates on Currency Rates

Elena Berseneva 08 february 2022 201 3

We examine one of the key aspects of determination of market rates of national currencies: interest rates set by national central banks.


At the beginning of our study, we will provide you with a simple and clear definition:


Interest rate is the interest at which the Central Bank of a country provides loans to commercial banks and accepts their deposited money.


According to this definition, we can assume that the higher the rate, the more expensive is money of the country against both goods sold in this country and currencies of other countries.


Thus, buying “cheap money” in order to sell them at a higher price is one of the most popular speculative and investment strategies. In particular, the Carry trade trading system is based on this ideawhich narrows down to currency trading according to the difference of interest rates of different countries.

Hypothesis
To conclusion

Changes in exchange rates are connected to changes in interest rates.

To conclusion

The following causal mechanism is expected: growth of the interest rate attracts foreign investors who seek the best option for profitability to invest their money in and this can be followed by increased demand for the country’s currency and thus consolidation of its rate.


How to test the hypothesis?


We will carry out the test by assessing correlation coefficients between the difference of interest rates of two countries and the dynamics of the exchange rates of the countries’ currencies.

Data used
  • The historical values of the interest rates of the Central Banks of Australia, the USA, the United Kingdom, the Eurozone, Canada, and Japan.
  • The historical values of quotes of 15 currency pairs formed from the currencies of the above-mentioned countries.


The used history of changes in interest rates:


Country
History of observation, years
Number of decisions on the rate
Australia
39
463
The USA
37
241
The United Kingdom
41
583
The Eurozone
20
229
Canada
26
273
Japan
11
141



Data sources on interest rates:


Country
Currency
Central Bank
Australia
The Australian Dollar (AUD)
The Reserve Bank of Australia
https://www.rba.gov.au/
The United Kingdom
The Pound Sterling (GBP)
the Bank of England
https://www.bankofengland.co.uk/
The Eurozone
The Euro (EUR)
the European Central Bank
https://www.ecb.europa.eu/home/html/index.en.html
Canada
The Canadian Dollar (CAD)
The Bank of Canada
https://www.bankofcanada.ca/
The USA
The US Dollar (USD)
The Federal Reserve System
https://www.federalreserve.gov/
Japan
The Japanese Jen (JPY)
The Bank of Japan
http://www.boj.or.jp/en/index.htm/


To assess changes in currency rates, we will use opening prices of 15 currency pairs over the daily timeframe.



The history of quotes of national currencies:


Country
The number of quotes
Australia
10050
8685
9772
10270
10287
The USA
8221
10197
10210
9781
10194
The United Kingdom
10292
10290
8692
10290
10282
The Eurozone
10244
10298
8691
10252
8685
Canada
7798
9782
9780
8691
9774
Japan
2642
2643
2643
2643
2643


The sample size reached 254 700 quotes after sampling on the daily timeframe.


Having determined the source of data and carried out the calculations with the previously listed methods, we now can move on to the obtained results:



Correlation


Currencies
USD
EUR
JPY
GBP
CAD
AUD
USD
0.27
0.44
0.35
0.15
0.14
EUR
0.27
0.26
0.73
-0.04
0.26
JPY
0.44
0.26
0.53
0.26
0.03
GBP
0.35
0.73
0.53
0.69
0.32
CAD
0.15
-0.04
0.26
0.69
0.14
AUD
0.14
0.26
0.03
0.32
0.14
Average
0.27
0.30
0.30
0.52
0.24
0.18


The average correlation coefficient for all currency pairs is 0.30.


The pairs with the British Pound, the Euro, and the Japanese Yen have the strongest direct link between interest rate changes and changes in currency rates.



Measurement of volatility


Also of interest are changes in volatility of the Forex market after the publication of decisions on interest rates.


Let us compare the daily volatility of currency pairs on the publication day with the average value of volatility of the preceding week and three weeks.


We use 1 930 news releases for six countries.



The average daily volatility, %


Country
On the day of publication
For the preceding week
For the three preceding weeks
Australia
1.04%
0.96%
0.97%
The USA
0.76%
0.63%
0.64%
The United Kingdom
0.93%
0.84%
0.85%
The European Union
1.24%
1.02%
1.02%
Canada
1.20%
1.07%
1.06%
Japan
1.17%
0.83%
0.85%
Average
1.06%
0.89%
0.90%


On days when the regulators publish decisions on rates, the volatility of the Forex market is on average 19.1% higher than during the preceding week, and by 17.7% higher in comparison with the average value of the preceding three-week period.



To illustrate graphically, we suggest observing the following charts. They show the correlation dynamics between the difference of interest rates of two countries and the relative rate of their currencies.

Conclusion

A positive correlation is indicated in all currencies but such pairs as the British Pound (0.52), the Euro (0.30), and the Japanese Yen (0.30) have the best-pronounced positive correlation.


In general, the average value of the correlation coefficient is 0.30 which indicates a weak correlation.


The volatility on the day of the publication of regulators’ decisions significantly increases, by 19.1% in comparison with the preceding week and by 17.7% in comparison with three preceding weeks.

XLSX (3.14 MB)Interest rates (part 1).xlsxXLSX (3.00 MB)Interest rates (part 2).xlsx

Comments

3

Write the comment

Commenting rules
Only authorized users can leave comments. Sign in, please.
Only users with verified email can leave comments. To verify your email, click on the link in the message that has been sent to your email address . Send an email for activation again.

Subscribe to our newsletter and stay up to date with all the news!