Forex-LIBOR correlations: EUR/USD 2002-2009

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Written by Forex Automaton   
Thursday, 12 March 2009 12:16
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Forex-LIBOR correlations: EUR/USD 2002-2009
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I use inter-market correlation to get a first-hand understanding of the connection between the interest rates and forex. I start with EUR/USD and, for the sake of uniformity, the respective ratio of LIBORs of various maturities. The correlation is a function of the time lag and in real life, in contrast with the efficient market assumption, its behavior with time lag is often informative. As usual, I pay particular attention to the non-zero time lags since these, when non-zero in a statistically significant way, quantify predictability of the time series, provided there are reasons to expect that some aspects of the time series repeat themselves over time. The present crisis and the preceding milder volatility period are studied separately and compared.

Executive summary: the correlation between LIBOR interest rates and forex should not be taken for granted. For example, in the pre-crisis period of 2002-2007, no correlation between shorter LIBOR maturities and EUR/USD is detected. During the crisis, long range correlations are seen in the movements of the instruments -- again surprising given the interest rate cuts and doubts about relevance of LIBOR fixing in the midst of a credit crunch.

EUR/USD bar chart 2002-2009, day scale.

Fig.1: EUR/USD bar chart, 2002-2009, day scale. Time axis is labeled in MM-YY format.

History of s/n-o/n LIBOR interest rate differential EUR-USD 2002-2009 History of 1-week LIBOR interest rate differential EUR-USD 2002-2009 History of 1-month LIBOR interest rate differential EUR-USD 2002-2009 History of 3-month LIBOR interest rate differential EUR-USD 2002-2009 History of 6-month LIBOR interest rate differential EUR-USD 2002-2009 History of 12-month LIBOR interest rate differential EUR-USD 2002-2009

Fig.2: History of EUR-USD LIBOR interest rates differential, top to bottom: s/n-o/n, 1-week, 1-month, 3-month, 6-month and 12-month. Time axis is labeled in MM-YY format, same range as in Fig.1.

The daily logarithmic returns of EUR/USD and daily logarithmic returns of the ratio of the respective LIBOR rates are the time series under correlation analysis. The EUR/USD was aggregated on a day scale specifically for this type of analysis, a "day" being defined to close at the moment of LIBOR fixing -- 11am London time.

It is more common to analyze the difference (Fig.2), and not the ratio, of interest rates. However, the logarithm calls for a positive quantity, and given questionable convergence of second moments of the "raw" quantities (as discussed by Mandelbrot), keeping the analysis logarithmic is very important.

The time evolution of EUR/USD and the LIBOR differential is show in Fig.2. As before, I define the visible phase of the present financial crisis, labeled B in figures, to begin on August 16, 2007, the day of Countrywide Financial near-bankruptcy event, followed by an extraordinary half-percent Fed discount rate cut next day. Fig.3 shows the time evolution of the correlation peak by plotting the correlation values for the negative and positive lags in separate panels.



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