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Explanation of Skewness of a currency and interest rate differential in that country?

The following plot is for the currencies in some developed countries: enter image description here

My questions are:

  1. How are skewness of a currency and interest rate differential defined respectively?

  2. Why is the relation between the two plotted in the figure? Is it somehow related to interest rate parity?

Thanks and regards!

Answer 1128

This figure means that the exchange rate between two currencies goes in the direction of the one that gives you the higher interest rate.

Explanation:

The skewness is the asymetry of the distribution. A negative skewness mean that you distribution goes to the right (ie, is more likely to gives you a positive outcome).

The positive interest rate differential between a currency A and B, means that you can borrow A at a cheaper rate than B. In other term, you can do a carry trade by: borrowing A, selling A to buy B and put B in a account. That operation will reward you with some interest rate.

Also, when the economies are in prosperity, most of the time, the currency with the higher interest rates goes up, while the one with the lowest interest rate goes down.

So, your graph means that a currency with a higher interest rate (positive 3-month interest rate differential) is more likely to appreciate (negative skewness). And that a currency with a lower interest rate (negative 3-month interest rate differential) is more likely to depreciate (positive skewness).

If you look at the NZD and AUD, you will see that they have both a high interest rate and that their exchange rate and going up when economy is fine. If you look at JPY you will see that Japan has a very low interest rate and that when economies are properous, the JPY goes down.

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