Forex Investment and Currency Trading

AUD/JPY and the evolution of risk

AUD/JPY 1-year implied volatilities had seemed to suggest that the worst of the financial crisis was passing in the wake of the collapse of Bear Stearns in mid-March. However, as uncertainty and risk aversion flared again, it became clear that the global financial crisis was fully entering Phase IV. AUD/JPY has very closely tracked the evolution of risk, as given by the AUD/JPY 1- year IV, since the crisis started in mid-2007. As AUD/JPY remains directionally sensitive to risk tolerance, the success of the US Treasury Secretary Paulson’s US$700bn financial bailout and central bank efforts to boost liquidity in markets. Of note, the Federal Reserve has opened swap lines with the RBA to allow a more global effort to deal with the USD funding crisis.

Global financial crisis: Phase IV

AUD/JPY has followed spreads, after adjusting for risk

The sensitivity of AUD/JPY to measures of risk helps explain why AUD/JPY had underperformed the widening of AUD-JPY interest rate spreads during the earlier phases of the crisis. In late 2007 AUD/JPY struggled as risk aversion increased even as 1-year and 2-year AUD-JPY swap spreads widened from around 6.0% to over 7.0%. However, AUD/JPY was consistent with the rates backdrop after adjusting swap spreads for risk. The Chart below presents the 1-year swap spread adjusted by using the 1-year
AUD/JPY implied volatility from Chart above, so that the swaps and the risk correction cover a comparable term. After the adjustment, the widening in swap spreads in late 2007 and early 2008 disappears. Spreads did not increase nearly enough to offset the sharp increase in implied volatilities.

AUD/JPY Has Tracked Risk-Adjusted Spreads

AUD/CAD has also closely followed AU-CA spreads

AUD and CAD tend to be lumped together as commodity/dollar bloc currencies, and AUD/CAD can be overlooked. To some extent this is justified as AUD/CAD has traded between 0.85 and 0.95 for much of the past three-years. However, AUD/CAD has quite closely tracked AU-CA interest rate spreads, appropriately adjusted for the risk in the cross rate. The 1-year AU-CA swap spread adjusted by the 1-year AUD/CAD implied volatility has closely tracked AUD/CAD. Importantly this relationship has
continued to hold during the recent financial market tumult. For AUD/CAD, despite the importance of commodities to both currencies, AU-CA rate spreads are a key factor.