By Erik Norland
Interest rate differentials between currencies can be crucial in foreign exchange markets for pricing purposes such as in the carry trade, and they have taken on added significance with the advent of negative rates in Europe and Japan over the past few years. So, how big are the interest rate differentials between currency pairs? On the face of it, it seems like a simple enough question. But the variety of ways used to measure the differential makes for a complicated answer. Differences in rates between central banks can be used as a guide but may be of limited value to everyday currency traders as only major financial institutions deal directly with central banks.
In financial theory, market participants would typically look at interbank rates, such as ICE LIBOR, as a guide. Unlike the official central bank rate, interbank rates offer a look at private sector lending rates. However, these rates may not reflect the rate differentials that currency traders are actually getting in the market. Also, the rates have been discontinued for several currencies.
Overnight index swap rates (OIS) such as EONIA can also be used to gauge the level of interest differentials among currencies. OIS rates, however, stick closely to central bank rates and may also not fully reflect the interest rate gaps currency investors are getting in the market.
Another avenue for calculating interest rate differentials is the currency market itself, where implied interest rate differentials can be calculated from the difference in the value of a currency in the spot and futures markets. For example, CME’s FX Swap Rate Monitor calculates the implied interest rate differential between CME FX futures and CME FX Link’s central limit order book (Figure 1).
Figure 1: FX markets shows larger interest rate differentials than other measures
What’s curious is that when these ways of measuring interest rate differentials are compared, the currency market measure consistently showed a larger interest rate gap between the US rate and the foreign currency rate than did central bank rates or the OIS. In other words, US interest rates appeared higher relative to other countries when observed …