Interest Rates and Volatility — correlation between interest rate gaps and volatility

Volatility in the currency markets is influenced by a number of factors foremost among which is the risk perception of financial actors. Risk, of course, can be defined in terms of many different variables including politics, natural disasters, in addition to the usual economic factors that always go into the calculation. But among those factors, arguably nothing is as important as interest rates in determining the level of long–term volatility in the forex market. Of course, this is not a one way relationship. Interest rates are themselves influenced by volatility, since the fluctuations caused by ongoing and long-term volatility strongly influence the decisions of central banks. Here we will take a look at the causes of the relationship between interest rates and volatility, and will attempt to determine its role in our choice of leverage and margin.
Volatility is a reflection of uncertainty. In a market where there’s no new information, volatility itself would be low or non-existent, but it is clear that the mere existence of a large number of market participants by itself creates volatility. Thus, there probably exists a state of minimal volatility below which no market activity would be possible. In other words, ordinary transactions necessary for the conduct of business and minimal economic activity would itself necessitate a minimal level of volatility in even the calmest markets. The question that we want to discuss here is about the impact of interest rates on the trade decisions of speculative actors and the bearing of their decisions on market volatility.