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Currency CorrelationsTo be an effective trader, understanding your overall portfolio's sensitivity to market volatility is important. But this is particularly so when trading forex. Because currencies are priced in pairs, no single pair trades completely independently of the others. Once you know about these correlations and how they change, you can take advantage of them to control over your portfolio's exposure. The reason for the interdependence of currency pairs is easy to see: if you were trading the
British pound against the Japanese yen (GBP/JPY pair), for example, you are
actually trading a kind of derivative of the GBP/USD and USD/JPY pairs;
therefore, GBP/JPY must be somewhat correlated to one if not both of these other
currency pairs. However, the interdependence among currencies stems from
more than the simple fact that they are in pairs. While some currency pairs will
move in tandem, other currency pairs may move in opposite directions, which is
in essence the result of more complex forces.
Correlation, in the financial world, is the statistical measure of the relationship between two securities. The ranges between -1 and +1. A correlation of +1 implies that the two currency pairs will move in the same direction 100% of the time. A correlation of -1 implies the two currency pairs will move in the opposite direction 100% of the time. A correlation of zero implies that the relationship between the currency pairs is completely random. Reading The Correlation Table With this knowledge of correlations in mind, let's look at the following
tables, each showing correlations between the major currency pairs for the month
of March 2005.
The upper table above shows that over the month of March (one month) EUR/USD and AUD/USD had very strong positive correlation of 0.94. This implies that when the EUR/USD rallies, the AUD/USD will also rally 94% of the time. Over the longer term (three months), though, the correlation is slightly weaker (0.47). In contrast, the EUR/USD and USD/CHF had a near-perfect negative correlation of -0.99. This implies that 99% of the time, when the EUR/USD rallies, USD/CHF will undergo a selloff. This relationship even holds true over longer periods as the correlation figures remain relatively stable.
Yet correlations do not always remain stable. Take USD/CAD and NZD/USD, for example. With a coefficient of -0.94, they had a strong negative correlation over the past year, but the relationship deteriorated over March 2005 for a number of factors, including the Reserve Bank of New Zealand's intentions to resume rate hikes, and political instability in Canada. Correlations Do Change It is clear then that correlations do change, which makes following the shift in correlations even more important.Sentiment and global economic factors are very dynamic and can even change on a daily basis.Strong correlations today might not be in line with the longer-term correlation between two currency pairs.That is why taking a look at the six-month trailing correlation is also very important.This provides a clearer perspective on the average six-month relationship between the two currency pairs, which tends to be more accurate.Correlations change for a variety of reasons, the most common of which include diverging monetary policies, a certain currency pair’s sensitivity to commodity prices, as well as unique economic and political factors. Here is a table showing the six-month trailing correlations that EUR/USD shares with other pairs:
Calculating Correlations Yourself
The best way to keep current on the direction and strength of your
correlation pairings is to calculate them yourself. This may sound difficult,
but it's actually quite simple.
To calculate a simple correlation, just use a spreadsheet, like Microsoft Excel. Many charting packages (even some free ones) allow you to download historical daily currency prices, which you can then transport into Excel. In Excel, just use the correlation function, which is =CORREL(range 1, range 2). The one-year, six-, three- and one-month trailing readings give the most comprehensive view of the similarities and differences in correlation over time; however, you can decide for yourself which or how many of these readings you want to analyze. Here is the correlation-calculation process reviewed step by step:
Even though correlations do change, it is not necessary to update your
numbers every day, updating once every few weeks or at the very least once a
month is generally a good idea.
How To Use It To Manage Exposure
Now that you know how to calculate correlations, it is time to go over how
to use them to your advantage.
First, they can help you avoid entering two positions that cancel each other out, For instance, by knowing that EUR/USD and USD/CHF move in opposite directions nearly 100% of time, you would see that having a portfolio of long EUR/USD and long USD/CHF is the same as having virtually no position - this is true because, as the correlation indicates, when the EUR/USD rallies, USD/CHF will undergo a selloff. On the other hand, holding long EUR/USD and long AUD/USD is similar to doubling up on the same position since the correlation is so strong. Diversification is another factor to consider. Since the EUR/USD and AUD/USD correlation is traditionally not 100% positive, traders can use these two pairs to diversify their risk somewhat while still maintaining a core directional view. For example, to express a bearish outlook on the USD, the trader, instead of buying two lots of the EUR/USD, may buy one lot of the EUR/USD and one lot of the AUD/USD. The imperfect correlation between the two different currency pairs allows for more diversification and marginally lower risk. Furthermore, the central banks of Australia and Europe have different monetary policy biases, so in the event of a dollar rally, the Australian dollar may be less affected than the Euro, or vice versa. A trader can use also different pip or point values for his or her advantage. Lets consider the EURUSD and USDCHF once again. They have a near-perfect negative correlation, but the value of a pip move in the EURUSD is $10 for a lot of 100,000 units while the value of a pip move in USDCHF is $8.34 for the same number of units. This implies traders can use USDCHF to hedge EURUSD exposure. Here's how the hedge would work: say a trader had a portfolio of one short
EUR/USD lot of 100,000 units and one short USD/CHF lot of 100,000 units. When
the EUR/USD increases by ten pips or points, the trader would be down $100 on
the position. However, since USDCHF moves opposite to the EURUSD, the short
USDCHF position would be profitable, likely moving close to ten pips higher, up
$83.40. This would turn the net loss of the portfolio into minus $16.60 instead
of minus $100. Of course, this hedge also means smaller profits in the event of
a strong EUR/USD sell-off, but in the worst-case scenario, losses become
relatively lower.
Regardless of whether you are looking to diversify your positions or find alternate pairs to leverage your view, it is very important to be aware of the correlation between various currency pairs and their shifting trends. This is powerful knowledge for all professional traders holding more than one currency pair in their trading accounts. Such knowledge helps traders, diversify, hedge or double up on profits. Summary To be an effective trader, it is important to understand how
different currency pairs move in relation to each other so traders can
better understand their exposure. Some currency pairs move in tandem with
each other, while others may be polar opposites. Learning about currency
correlation helps traders manage their portfolios more appropriately. Regardless
of your trading strategy and whether you are looking to diversify your positions
or find alternate pairs to leverage your view, it is very important to keep in
mind the correlation between various currency pairs and their shifting
trends. |
